(navigation image)
Home American Libraries | Canadian Libraries | Universal Library | Community Texts | Project Gutenberg | Children's Library | Biodiversity Heritage Library | Additional Collections
Search: Advanced Search
Anonymous User (login or join us)
Upload
See other formats

Full text of "Description of possible options to increase revenues"

[JOINT COMMITTEE PRINT] 



DESCRIPTION OF POSSIBLE OPTIONS 

TO INCREASE REVENUES 

PREPARED FOR THE 

COMMITTEE ON WAYS AND MEANS 



By the Staff of the 
JOINT COMMITTEE ON TAXATION 

With the Staff 

OF THE 

COMMITTEE ON WAYS AND MEANS 




JUNE 25, 1987 



U.S. GOVERNMENT PRINTING OFFICE 
74-267 WASHINGTON : 1987 JCS-17-87 



For sale by the Superintendent of Documents, U.S. Government Printing Office 
Washington, DC 20402 



CONTENTS 



Page 

Introduction ix 

I. Revenue Areas Addressed By the President's 1988 

Budget Proposals 1 

A. Employment Tax Provisions 1 

1. Extend Medicare payroll tax to all State and 

local government employees 1 

2. Expand employer share of FICA tax to include all 

cash tips 3 

3. Extend FICA tax to inactive duty earnings of 

military reservists and certain other earnings 5 

4. Treatment of group-term life insurance as wages 

under FICA 7 

5. Railroad retirement tax proposals 9 

a. Increase in railroad retirement payroll tax 9 

b. Partial rail sector financing of vested dual 

benefits 10 

c. Extend FUTA tax to railroad employment 10 

B. Excise Tax Provisions 12 

1. Proposals relating to black lung benefits 12 

a. Increase in coal excise tax 12 

b. Inclusion of black lung cash benefits in gross 

income 13 

2. Repeal of current gasohol, bus, and State and 

local government highway excise tax exemp- 
tions 15 

3. Airport and Airway Trust Fund excise taxes 17 

4. Imposition of air and ship travel tax 19 

5. Repeal of crude oil windfall profit tax 21 

C. PBGC Premiums 24 

D. Certain New User Fees 27 

1. Internal Revenue Service 27 

2. Bureau of Alcohol, Tobacco and Firearms 28 

3. Customs Service 30 

4. Coast Guard 32 

(III) 



IV 

Page 

II. Other Possible Revenue Options 35 

A. Excise Taxes 35 

1. Alcoholic beverage excise taxes 

2. Tobacco products excise taxes 

3. Telephone excise tax 

4. Luxury excise taxes 

5. Firearms excise taxes 

6. Pollution excise taxes 

a. Excise tax on sulfur and nitrogen emissions ... 

b. Tax on ozone depleting chemicals 

7. Energy consumption taxes 

a. Broad-based energy tax 

b. Broad-based petroleum tax 

c. Oil import tax 

8. Motor fuels excise taxes 

a. Increase in excise tax rates 

b. Collection of gasoline and diesel fuel excise 

taxes 

c. Income tax credit and excise tax exemption 

for certain alcohol fuels 

9. Gas guzzler excise tax 

10. Increase Trust Fund excise taxes by an amount 
to offset implicit general fund contributions 

11. Federal Unemployment Tax Act (FUTA) provi- 
sions 

a. Index FUTA wage base 

b. Extension of portion of FUTA due to expire 

after 1987 

B. General Consumption Taxes 

1. Value added tax (VAT) 

2. Business alternative minimum tax (BAMT) 

C. Securities Transfer Excise Tax 

D. Income Tax Provisions 

1. Individual and corporate tax rates and surtaxes.... 

2. Reduction in individual and corporate tax prefer- 

ences 

3. Individual income tax provisions 

a. Credit for child and dependent care expenses . 

b. Interest expense deduction on home equity 

loans 

c. Other itemized deductions 

(1) Disallowance of deduction for nonbusi- 

ness personal property taxes 

(2) Imposition of floor under aggregate 

itemized deductions for higher-income 
taxpayers 



V 

Page 

(3) Limitation on tax-liability reduction for 

top-bracket individuals 100 

4. Business meal and entertainment expenses 101 

5. Employee benefits; Pensions; ESOPs 102 

a. Employee benefits 102 

(1) Limit the exclusion of employer-provid- 

ed health coverage 102 

(2) Repeal the exclusion of employer-provid- 

ed group-term life insurance 105 

(3) Repeal the $5,000 exclusion for employ- 

er-provided death benefits 107 

(4) Repeal the exclusion of employer-provid- 

ed dependent care assistance 109 

(5) Repeal the exclusions for employee ben- 

efits with respect to high-income em- 
ployees Ill 

(6) Limit the exclusion for cafeteria plan 

benefits 113 

(7) Exclusion from income for meals and 

lodging 116 

b. Pensions 118 

(1) Treat loans from qualified plans as dis- 

tributions 118 

(2) Redefine full funding limitation for pen- 

sion plans 120 

(3) Definition of active participant for IRA 

rules 122 

c. Repeal certain special rules relating to 

ESOPs 124 

6. Accounting provisions 128 

a. Accrual accounting requirement for large 

nonfarm businesses 128 

b. LIFO method of inventory accounting 130 

c. Accounting for long-term contracts 133 

d. Repeal of vacation pay reserve 136 

e. Limitations on deductibility of advertising 

costs..... 138 

f. Elimination of deferral of income of coopera- 

tives 140 

g. Current accrual of market discount on bonds . 142 

h. Installment sales 144 

i. Amortization of intangibles 146 

j. Disallow interest deductions allocable to tax- 
exempt installment sales of property to 

State or local governments 149 

k. Below-market loans to certain continuing 

care facilities 152 

7. Farming provisions 154 

a. Accrual accounting requirement for large 

farming businesses 154 

b. Treat farm losses like real estate losses 

under the passive loss rules 156 

c. Increase cost recovery period for single pur- 

pose agricultural structures 158 



VI 

Page 

8. Financial institutions 159 

a. Repeal tax-exempt status of credit unions 159 

b. Tax treatment of recoveries of bad debts of 

thrift institutions , 161 

9. Corporate provisions 163 

a. Intercorporate dividends received deduction ... 163 

b. Modify computation of earnings and profits 

for intercorporate dividends and basis ad- 
justments {Woods Investment Company) 166 

c. Limit consolidated return pass-through 169 

d. Debt financing and corporate acquisitions 171 

e. Stock redemptions 175 

f. Tax benefit mergers 178 

g. Limit sales of losses using preferred stock 180 

h. Limitations on net operating loss carryfor- 
wards of corporation following worthless se- 
curities deduction by shareholders 182 

i. Deemed dividends to corporate shareholders ... 184 

j. Affiliation rules for Alaska Native Corpora- 
tions 186 

k. Denial of graduated rates for personal serv- 
ice corporations 188 

1. Conversion of C corporation to S status 189 

10. Partnership provisions 191 

a. Master limited partnerships (MLPs) 191 

b. Partnership allocations 194 

c. Transactions between partners and partner- 

ships 196 

d. Partnership-level income computation 198 

11. Depreciation provisions 200 

a. Determine recovery period of property by ref- 

erence to 125 percent of lease or other con- 
tract term 200 

b. Limitations on depreciation deductions for 

luxury automobiles 202 

c. Income forecast method of amortization 204 

12. Foreign tax provisions 206 

a. Title passage source rule and 50-50 produc- 

tion/marketing split 206 

b. Income from runaway plants 209 

c. Withholding tax on interest paid to foreign- 

ers 211 

d. Deduction for interest paid to exempt entities 213 

e. Treatment of South African income 216 

f. Foreign earned income exclusion 219 

13. Insurance and annuities 221 

a. Life insurance policies, including single pre- 

mium or investment-oriented policies 221 

b. Life insurance company consolidation 228 

c. Treatment of nonprofit insurance providers.... 230 

d. Treatment of foreign life insurance compa- 

nies 232 

e. Minimum tax treatment of mutual life insur- 

ance companies 234 



VII 

Page 

f. Treatment of certain insurance syndicates 236 

g. Capitalize agents' commissions 238 

14. Capital gains 240 

a. Like-kind exchanges 240 

b. Individual capital gains 242 

15. Alternative minimum tax 243 

16. Natural resources 246 

a. Oil and gas working interests 246 

b. Percentage depletion 248 

c. Intangible drilling costs 250 

17. Compliance 252 

a. Estimated taxes 252 

b. IRS funding 254 

c. Withholding 255 

d. Collection of debts owed to Federal agencies... 256 

e. Escheat of refunds 257 

E. Gift, Estate, and Generation-Skipping Taxes 258 

1. Rates and unified credit 258 

2. Repeal of the "stepped-up basis" rule 261 

3. Taxation of life insurance 263 

4. Valuation of property: estate freezes and minori- 

ty discounts 265 

5. State death tax credit 268 

6. Definition of present interest for purposes of the 

annual gift tax exclusion 269 

7. Estate tax deduction for sales to an ESOP or 

worker-owned cooperative 270 

F. Tax-Exempt Organizations 272 

1. Unrelated business income tax on certain trade 

association income 272 

2. Excise tax on net investment income of exempt 

organizations 275 

3. Unrelated business income tax — equity kickers on 

loans to business ventures 277 



INTRODUCTION 

This pamphlet, ^ prepared by the staff of the Joint Committee on 
Taxation in conjunction with the staff of the House Committee on 
Ways and Means, provides a brief description of various possible 
options to increase revenues. 

The pamphlet was prepared at the request of Committee on 
Ways and Means Chairman Rostenkowski for the use of the Com- 
mittee on Ways and Means in its consideration of revenue propos- 
als in connection with the fiscal year 1988 Budget Resolution. Com- 
mittee hearings have been scheduled for July 7, 8, and 9, 1987, on 
options for achieving the revenue reconciliation targets under the 
fiscal year 1988 Budget Resolution. These hearings will not include 
further testimony on either the particular Administration fiscal 
year 1988 budget proposals or any other proposals on which the 
Committee (or its subcommittees) have already held hearings. 

The first part of the pamphlet describes the revenue proposals 
contained in the President's Fiscal Year 1988 Budget (submitted to 
Congress on January 5, 1987). The second part of the pamphlet de- 
scribes certain other possible revenue options. For each item, there 
is a summary description of present law, the President's budget 
proposal (where applicable), possible proposals, arguments for and 
against the proposals, and estimated revenue effects (if available by 
the publication date). The third part provides a table of the esti- 
mated revenue effects of the proposals included in parts one and 
two (if available). 

The revenue options in this pamphlet are not proposals or recom- 
mendations of the staff of the Joint Committee on Taxation or of 
the staff of the Committee on Ways and Means, but rather options 
that the Committee on Ways and Means may wish to consider in 
connection with legislation relating to revenue reconciliation tar- 
gets under the fiscal year 1988 Budget Resolution. The possible pro- 
posals described in the pamphlet include those submitted by Mem- 
bers of the Committee at the request of Chairman Rostenkowski. 



* This pamphlet may be cited as follows: Joint Committee on Taxation, Description of Possible 
Options to Increase Revenues Prepared for the Committee on Ways and Means (JCS-17-87), June 
25, 1987. 

(IX) 



I. REVENUE AREAS ADDRESSED BY THE PRESIDENT'S 1988 
BUDGET PROPOSALS 

A. Employment Tax Provisions 

1. Extend Medicare Payroll Tax to All State and Local Govern- 
ment Employees 

Present Law 

Before enactment of the Consolidated Omnibus Budget Reconcili- 
ation Act of 1985 (COBRA) (P.L. 99-272), State and local govern- 
ment employees were covered for social security and Medicare ben- 
efits only if the State and the Secretary of Health and Human 
Services (HHS) entered into a voluntary agreement providing such 
coverage. In COBRA, the Congress extended Medicare coverage 
(and the corresponding hospital insurance payroll tax) on a manda- 
tory basis to State and local government employees hired after 
March 31, 1986, for services performed after that date. Under 
present law. State and local government employees hired before 
April 1, 1986, still are not covered for Medicare unless a voluntary 
agreement is in effect. Currently, 70 percent of all State and local 
government employees are covered under a voluntary agreement. 
Medicare coverage (and the hospital insurance payroll tax) is man- 
datory for Federal employees. 

For wages paid in 1987 to Medicare-covered employees, the total 
hospital insurance tax rate is 2.9 percent of the first $43,800 of 
wages; the tax is divided equally between the employer and the em- 
ployee. 

President's Budget Proposal 

The President's budget proposal would extend Medicare coverage 
on a mandatory basis to all employees of State and local govern- 
ments not otherwise covered under present law, without regard to 
their dates of hire. These employees and their employers would 
become liable for the hospital insurance portion of the tax under 
the Federal Insurance Contributions Act (FICA) and the employees 
would earn credit toward Medicare eligibility based on their cov- 
ered earnings. 

This proposal would be effective January 1, 1988. 

Pros and Cons 
Arguments for the proposal 

1. The current population survey conducted by the Bureau of the 
Census using March 1985 survey data found that 94 percent of indi- 
viduals age 65 or older who reported receipt of a State or local gov- 
ernment pension were eligible for Medicare. This is attributable to 

(1) 



the fact that many State and local government employees who 
were not subject to the hospital insurance portion of the FICA tax 
are entitled to receive Medicare coverage due to other employment 
or spousal Medicare eligibility. Thus, it is only fair that State and 
local government employees hired before April 1, 1986, pay the hos- 
pital insurance portion of the FICA tax, just as Federal govern- 
ment employees. State and local government employees hired after 
March 31, 1986, and private sector employees do. 

2. The benefits of Medicare coverage should be extended to all 
employees of State and local governments. 

Arguments against the proposal 

1. Requiring State and local governments to pay the hospital in- 
surance portion of the FICA tax for employees hired before April 1, 
1986, would impose a significant cost burden on State and local 
governments. The COBRA legislation effectively phases in the 
burden of the tax. 

2. State and local governments should retain the right to decide 
how to structure the retirement benefits of their employees hired 
before April 1, 1986. 

Revenue Effect 

[Fiscal years, billions of dollars] 
Proposal 1988 1989 1990 1988-90 

Extend Medicare payroll tax to 
all State-local government 
employees 1.3 1.9 1.9 5.2 



2. Expand Employer Share of FICA Tax to Include All Cash Tips 

Present Law 

The FICA taxes imposed on the employee and the employer gen- 
erally are equal. The employer is responsible for withholding the 
employee's share of the tax from the employee's wages and remit- 
ting the tax, together with the employer's share of the tax, to the 
Internal Revenue Service. The current tax rate for both the em- 
ployer and the employee is 7.15 percent of wages, consisting of 5.7 
percent for Old- Age, Survivors and Disability Insurance and 1.45 
percent for Medicare Hospital Insurance. 

Special rules apply to tips, however. For purposes of the employ- 
ee FICA tax, tips received by employees are considered remunera- 
tion for services and are subject to the tax. The tips are generally 
deemed to be received at the time the employee files a written 
statement with the employer reporting the receipt of the tips. 

The full amount of tips received by an employee is not, however, 
usually subject to the FICA tax imposed on the employer. The em- 
ployee is deemed to receive wages for purposes of the employer's 
share of FICA taxes only to the extent of the excess of the Federal 
minimum wage rate over the actual wage rate paid by the employ- 
er. Any tips received in excess of the difference between the wages 
paid and the minimum wage are not subject to the employer's por- 
tion of the tax. 

President's Budget Proposal 

Under the President's budget proposal, all cash tips would be in- 
cluded within the definition of wages for purposes of the employ- 
er's share of FICA taxes. Thus, employers would be required to pay 
FICA taxes on the total amount of cash tips up to the Social Secu- 
rity wage base. 

This proposal would be effective January 1, 1988. 

Pros and Cons 
Arguments for the proposal 

1. Benefits paid to employees are based on total cash tips. Em- 
ployees must report and pay FICA tax on the total amount of tips 
received while employers must only pay FICA tax on a portion of 
such tips. This acts as a subsidy to the employer. In effect, tipped 
employees accrue a given benefit with lower contributions than 
any other employees covered by Social Security. 

2. Implementation of this proposal would ease an administrative 
burden on the Social Security Administration ("SSA"). Currently, 
the SSA must maintain separate records of the amount of reported 
tips for tax accountability purposes. Each year the U.S. Treasury 
transfers to the Social Security trust fund the amount of FICA 

(3) 



4 

taxes due on the total wages reported to the SSA during the prior 
year. Because no FICA taxes are paid by the employer on tips 
(other than the amount necessary to bring the employee's salary 
up to the minimum wage), the SSA must keep a separate record of 
tips so that it will be able to tell the Treasury Department the 
total amount of wages on which both employer and employee taxes 
are due and the total amount on which only employee taxes are 
due. 

Arguments against the proposal 

1. It is unfair to employers to tax them on amounts paid directly 
by customers to employees. 

2. In the case of an individual who is employed by more than one 
employer, withholding may be applied on total wages in excess of the 
Social Security wage base. 

Revenue Effect 

[Fiscal years, billions of dollars] 
Proposal 1988 1989 1990 1988-90 

Expand employer share of FICA 
tax to include all cash tips 0.2 0.3 0.3 0.8 



3. Extend FICA Tax to Inactive Duty Earnings of Military Reserv- 
ists and Certain Other Earnings 

Present Law 

The Social Security System is financed by payroll taxes imposed 
under the Federal Insurance Contributions Act C'FICA"). The 1987 
rates of this tax are 7.15 percent paid by employers and 7.15 per- 
cent paid by employees on wages (up to a maximum of $43,800). An 
employee only receives Social Security credit for his earnings if his 
salary constitutes wages and if his job is included in the definition 
of employment ("covered employment") under section 3121. The 
Act generally defines wages to include all remuneration for em- 
plojnnent but provides specific exemptions. 

President's Budget Proposal 

The President's budget proposal would eliminate the exemption 
from the definition of wages for several categories of earnings. The 
exemption would be repealed for the following: 

(a) Armed Forces Reservists. — Approximately 1.4 million Armed 
Forces reservists do not receive Social Security credit and are not 
subject to Social Security taxes for their inactive duty earnings, be- 
cause "inactive duty training" (generally, weekend training drill 
sessions) has not been included as covered employment under sec- 
tion 3121. Earnings from full-time active duty or from "active duty 
for training" (training sessions lasting several weeks) constitute 
covered employment under current law. 

(b) Students. — Services performed by a student under various cir- 
cumstances in an academic setting are excluded from coverage 
under Social Security and the student's wages are not subject to 
FICA taxes. Such students include those employed by a school they 
are attending (or college club or an auxiliary nonprofit organiza- 
tion of a school) and student nurses employed by a hospital or 
nurses' training school they are attending. 

(c) Agricultural workers. — Under present law, cash remuneration 
paid to an employee in any taxable year for agricultural labor is 
excluded from the definition of wages unless the employee receives 
more than $150 during the year for such labor or the employee 
works for the employer more than 20 days during the year. 

(d) Individuals Aged 18-21. — Services performed by individuals 
under age 21 who are employed by their parents, even if employed 
in the parent's trade or business, do not currently constitute cov- 
ered employment. 

(e) Spouses. — Services performed by an individual in the employ 
of his spouse do not constitute covered employment. 

These proposals would be effective January 1, 1988. 

(5) 



Pros and Cons 
Argument for the proposal 

Currently, some individuals such as Armed Forces reservists do 
not receive social security credit for their earnings. Elimination of 
these exemptions from covered employment would provide more 
equitable coverage of such individuals. 

Argument against the proposal 

The administrative burden involved in extending FICA taxes to 
these groups outweighs the equity in coverage of these types of 
earnings. 

Revenue Effect 

[Fiscal years, billions of dollars] 
Proposal 1988 1989 1990 1988-90 

Extend FICA tax to inactive duty earn- 
ings of military reservists and cer- 
tain other earnings 0.2 0.3 0.3 0.7 



4. Treatment of Group-Term Life Insurance as Wages Under 
FICA 

Present Law 

The cost of group-term life insurance provided by an employer to 
an employee is excluded from the definition of wages for purposes 
of the FICA tax. In 1987, the first $43,800 of wages is subject to a 
total FICA tax of 14.3 percent. One-half of this tax (7.15 percent) is 
paid by the employee and one-half is paid by the employer. 

For income tax purposes, in general, the cost of employer-provid- 
ed group-term life insurance is includible in an employee's income 
to the extent that the coverage exceeds $50,000. Employer-provided 
group-term life insurance also is included in an employee's income 
if the coverage is provided under a plan that fails to satisfy nondis- 
crimination and qualification requirements. 

President's Budget Proposal 

Under the Administration proposal, employer-provided group- 
term life insurance would be included in wages for FICA tax pur- 
poses to the extent such insurance is includible in income for 
income tax purposes. 

This proposal would be effective January 1, 1988. 

Pros and Cons 
Arguments for the proposal 

1. The exclusion from wages of employer-provided group-term life 
insurance can result in taxpayers having the same economic 
income paying different amounts of FICA tax because of the form 
in which their compensation is received. In addition, the exclusion 
from wages of employer-provided group-term life insurance nar- 
rows the FICA tax base, thereby requiring higher tax rates to gen- 
erate a given amount of revenues. 

2. The proposal would allow low- and middle-income employees 
to earn credit toward social security benefits by virtue of compen- 
sation received in the form of group-term life insurance. 

Arguments against the proposal 

1. The exclusion from wages of employer-provided group-term life 
insurance is justified, as a matter of social policy, by the fact that 
the nondiscrimination requirements for such exclusion encourage 
the provision by employers of group-term life insurance to low- and 
middle-income employees who otherwise might not purchase such 
insurance. 

2. If the proposal were enacted, employers would be less likely to 
provide group-term life insurance to low- and middle-income em- 
ployees. In addition, many of such employees would not purchase 

(7) 



8 

life insurance on their own. Accordingly, their survivors may in 
some cases need public assistance, since social security survivor 
benefits often are inadequate. The cost of providing this assistance 
may well exceed the cost of retaining the present-law exclusion of 
employer-provided group-term life insurance from wages. 

Revenue Effect 

[Fiscal years, billions of dollars] 
Proposal 1988 1989 1990 1988-90 

Treatment of group-term life insur- 
ance as wages under FICA (i) 0.1 0.1 0.2 

^ Gain of less than $50 million. 



5. Railroad Retirement Tax Proposals 

a. Increase in railroad retirement payroll tax 
Present Law 

The primary source of income to the railroad retirement account 
is payroll taxes levied on covered employers and their employees. 
Currently, both employers and employees pay a Tier I tax which is 
equivalent to the social security tax rate. In addition, a Tier II tax 
is paid by both rail employers and employees. These taxes are ap- 
plied to compensation paid to employees, up to a maximum annual 
amount. Under present law, the Tier II tax rate is 14.75 percent for 
employers and 4.25 percent for employees. The Tier II wage base in 
1987 is $32,700. 

Pursuant to the Railroad Retirement Solvency Act, the Railroad 
Retirement Board on June 16, 1987 submitted an actuarial report on 
the status of the railroad retirement system. As part of this report, 
the Chairman of the Board recommended a 3 percent increase in 
the tier 2 tax rate as of January 1, 1988. The Board's Chief Actuary 
submitted a recommendation to increase the tier 2 tax rate by 4.5 
percent on January 1, 1988. The Actuary also suggested the estab- 
lishment of a body to study the merits of a tax on operating funds 
to underwrite a portion of railroad retirement benefit costs. The 
Chief Actuary's report was not supported by the Management 
Member of the Board but was supported by the Labor Member who 
additionally suggested that the entire increase be borne by the rail 
employers. 

President's Budget Proposal 

The President's budget proposal would increase the railroad re- 
tirement Tier II taxes by 3.0 percentage points. This increase would 
be achieved in two steps — a 1.5 percentage point increase, effective 
January 1, 1988, and an additional 1.5 percentage point increase ef- 
fective January 1, 1989. (The proposal does not describe how this in- 
creased tax would be apportioned between emloyers and employees. 

Pros and Cons 
Argument for the proposal 

Additional revenues are needed to ensure the medium- and long- 
range solvency of the Rail Industry Pension Fund. 

Argument against the proposal 

Increases in the level of pension contributions by both employers 
and employees will present an even greater barrier to employment 
in an aging yet important national industry. 

(9) 



10 

b. Partial rail sector financing of vested dual beneflts 

Present Law 

Under present law, vested dual benefits are payable to retired 
rail workers who had the equivalent of 10 years' coverage under 
both railroad retirement and social security prior to 1975. These 
benefits, which phase out over time, are financed by general reve- 
nues. 

President's Budget Proposal 

The President's budget proposal would require the rail industry 
to finance 25 percent of the cost of vested dual benefits. This fi- 
nancing would be derived from the rail industry pension fund, 
which is funded by Tier II payroll taxes. 

The proposal would include an increase in the Tier II payroll 
taxes to finance the cost borne by the rail industry pension fund. 
(This increase would be in addition to the 3.0 percent increase in 
Tier II taxes described above.) The proposal does not describe how 
the increase of Tier II taxes would be apportioned between employ- 
ers and employees. 

Pros and Cons 
Argument for the proposal 

General revenue financing of vested dual benefits amounts to a 
taxpayer subsidy of railroad retirees, and should be partially offset 
by rail sector contributions. 

Argument against the proposal 

Vested dual benefits are a product of non-railroad employment, 
rather than railroad employment and thus, should be financed by 
general revenues, as was originally established in 1974. 

c. Extend FUTA tax to railroad employment 

Present Law 

Under present law, railroad employment is not covered by the 
Federal-State unemployment insurance system. Instead, railroad 
employees are covered by a separate Railroad Sickness and Unem- 
ployment Insurance Fund, which is financed by payroll taxes levied 
on rail employers. 

The railroad unemployment insurance (RRUI) program has per- 
manent authority to borrow from the railroad retirement program 
in order to pay RRUI benefits. The Railroad Retirement Solvency 
Act of 1983, as modified by the Consolidated Omnibus Budget Rec- 
onciliation Act of 1985 (COBRA), established a loan repayment tax, 
beginning at 4.3 percent on July 1, 1986, and changing to 4.7 per- 
cent for 1987, 6.0 percent for 1988, 2.9 percent for 1989, and 3.2 per- 
cent for 1990. The tax expires after September 30, 1990. 

COBRA further provided that an automatic surcharge of 3.5 per- 
cent on the loan repayment tax base will be levied if the RRUI pro- 
gram has to borrow from the retirement program. The surtax pro- 
ceeds are to be used to repay such loans made after September 30, 



11 

1985, and is in effect for any year if on September 30 of the prior 
year any principal or interest from a loan after September 30, 1985 
remains unpaid. 

As mentioned above, the Railroad Retirement Board issued a 
report on finances on June 16, 1987. As part of this report, the 
Chairman of the Board recommended an extension of the special 
repayment tax required to retire the debts of the Railroad Unem- 
ployment and Sickness Insurance Account. Similar recommenda- 
tions were made by the Chief Actuary and the Labor Member of 
the Board. 

President's Budget Proposal 

The President's budget proposal would extend coverage under 
the Federal-State unemployment insurance system to railroad em- 
ployment. In addition, a transitional program would be developed 
to guarantee certain levels of benefits for rail workers who became 
unemployed after September 30, 1987. The Railroad Sickness and 
Unemployment Insurance Fund would continue to finance sickness 
payments and to repay the Fund's debt to the rail industry pension 
fund. 

This proposal would be effective October 1, 1987. 

Pros and Cons 
Argument for the proposal 

Currently, the Railroad Sickness and Unemployment Insurance 
Fund is experiencing financial difficulty and has required loans 
from the Railroad Industry Pension Fund in the past to avoid insol- 
vency. Given these circumstances, the more financially sound Fed- 
eral/State unemployment insurance system should assume cover- 
age of railroad workers. 

Argument against the proposal 

The railroad industry historically has maintained separate funds 
for its retirees and unemployed. Levels of contributions mandated 
by recent legislation have moved these funds closer to financial sta- 
bility and therefore integration with the Federal-State unemploy- 
ment system is unnecessary. 

Revenue Effect 

[Fiscal years, billions of dollars] 
Proposal 1988 1989 1990 1988-90 

a. Increase in railroad retire- 
ment payroll tax 

b. Partial rail sector financing 
of vested dual benefits 

c. Extend FUTA tax to railroad 
employment 



0.1 


0.2 


0.3 


0.6 


0.1 


0.1 


0.1 


0.2 


0.1 


0.1 


0.1 


0.4 



B. Excise Tax Provisions 
1. Proposals Relating to Black Lung BeneHts 
a. Increase in coal excise tax 

Present Law 

A manufacturers excise tax is imposed on the sale or use of do- 
mestically mined coal (other than lignite) by the producer (sees. 
4121, 4218). The Consolidated Omnibus Budget Reconciliation Act 
of 1985 (COBRA) increased the rate of the tax by 10 percent, effec- 
tive April 1, 1986, to $1.10 per ton of coal from underground mines, 
and 55 cents per ton of coal from surface mines. However, the 
amount of tax may not exceed 4.4 percent of the sales price. 

Amounts equal to the revenues collected from the coal excise tax 
are appropriated automatically to the Black Lung Disability Trust 
Fund. The Trust Fund pays certain black lung disability benefits to 
coal miners (or their survivors) who have been disabled by black 
lung disease in cases where no coal mine operator is found specifi- 
cally responsible for the individual miner's disease. Present law in- 
cludes an unlimited authorization for advances, generally repay- 
able with interest, from the general fund to the Trust Fund. How- 
ever, COBRA provided a five-year moratorium on interest accruals 
(from September 30, 1985 to October 1, 1990) with respect to repay- 
able advances to the Trust Fund. 

Under present law, the tax will revert to 50 cents on under- 
ground coal and 25 cents on surface coal (subject to a limit of two 
percent of price) on the earlier of January 1, 1996, or the first Jan- 
uary 1 as of which there is (1) no balance of repayable advances 
made to the Trust Fund, and (2) no unpaid interest on such ad- 
vances. 

President's Budget Proposal 

The President's budget proposal would increase the excise tax to 
$1.70 per ton for coal from underground mines and $0.85 per ton 
for coal from surface mines, subject to a cap of 6.8 percent of the 
sales price. This rate would apply through 1990, with decreasing 
rates thereafter. In addition, the proposal would repeal the five- 
year moratorium on interest accruals on repayable advances to the 
Trust Fund. 

The Administration also has proposed certain changes to slow 
the growth of black lung benefit payments, including a one-year 
freeze on cost-of-living adjustments for benefits. The Administra- 
tion estimates that its excise tax and related benefit proposals 
would eliminate the Trust Fund deficit by the year 2007. As of the 
beginning of fiscal year 1987, the deficit (i.e., the amount of ad- 
vances repayable to the general fund) was $2.9 billion. 

(12) 



13 

Pros and Cons 
Arguments for the proposal 

1. The Black Lung Trust Fund should be placed on an actuarially 
sound basis by increasing the coal excise tax and adopting other 
parts of the Administration proposal. While the 10-percent increase 
enacted in COBRA may allow the Trust Fund to achieve operation- 
al solvency, that increase will not be sufficient to achieve retire- 
ment of the Trust Fund's indebtedness to the general fund. 

2. The Administration proposal is intended to carry out the 
intent of the Congress that full financial responsibility for the 
black lung benefits program should be borne by the coal industry 
for post-1973 claimants. The general fund would continue to fund 
approximately $1 billion annually in black lung benefits to certain 
pre-1974 claimants. 

Arguments against the proposal 

1. When COBRA was enacted in 1986, the Congress carefully bal- 
anced the financial needs of the Trust Fund and the depressed 
state of the coal industry. The further tsix increases proposed by 
the Administration would adversely affect the ability of U.S. coal 
companies to compete with foreign coal in international markets 
and with other fuel sources in the domestic market. 

2. Since the Trust Fund deficit can be viewed as attributable to 
the excessively liberal eligibility requirements for benefits that ap- 
plied under prior law, it would be unfair to impose additional tax 
increases on the coal industry to fund retroactively claim payments 
that were not based on adequate medical evidence establishing dis- 
ability from black lung disease. 

b. Inclusion of black lung cash beneflts in gross income 
Present Law 

Title IV of the Federal Coal Mine Health and Safety Act pro- 
vides for payment of monthly cash benefits to eligible coal miners 
who are totally disabled by black lung disease and to their survi- 
vors. Also, a coal miner receiving black lung cash benefits is eligi- 
ble for related medical and rehabilitation benefits. 

Under present law, black lung disability benefits are excludable 
from gross income as workers' compensation benefits (Rev. Rul. 72- 
400, 1972-2 C.B. 75). 

President's Budget Proposal 

Under the President's budget proposal, black lung cash benefits 
would be includible in the recipient's gross income. (The value of 
medical and rehabilitation benefits received by a disabled miner 
would continue to be excludable from income.) 'This proposal would 
be effective January 1, 1988. 



14 

Pros and Cons 
Arguments for the proposal 

1. Black lung cash benefits can be viewed essentially as wage re- 
placement payments and therefore should be included in the recipi- 
ent's gross income. For similar reasons, disability payments under 
employer-provided plans generally are includible in the recipient's 
gross income, as are all unemployment compensation benefits. The 
treatment of wage replacement payments in the same manner as 
wages or similar compensation (such as sick pay) contributes to 
more equal tax treatment of individuals with the same economic 
income. 

2. Recipients of black lung benefits who are low-income individ- 
uals would receive tax relief through the increased standard deduc- 
tion and personal exemption amounts and the lower tax rates en- 
acted in the 1986 Act. This represents a more appropriate approach 
to providing tax relief to low-income individuals than using a spe- 
cial preference for one type of wage replacement payments avail- 
able only to workers in one industry. The Administration proposal 
would continue to exclude from income the value of black-lung 
medical and rehabilitation benefits; this approach is consistent 
with the general exclusion of employer-provided health care. 

Arguments against the proposal 

1. Black lung benefits can be viewed as essentially similar to per- 
sonal injury damages and hence should not be taxed to the recipi- 
ent. This approach is consistent with the general present-law exclu- 
sions for amounts (1) received under workers' compensation acts as 
compensation for personal injuries or sickness, or as benefits to a 
survivor of a deceased employee; (2) received for personal injuries 
under an employer-provided accident and health plan, if deter- 
mined without regard to the period of the employee's absence from 
work; and (3) for damage payments under tort law for personal in- 
juries or sickness. 

2. The present-law exclusion appropriately recognizes that many 
recipients of black lung benefits need the full amount of the pay- 
ments, unreduced by taxes, to maintain a subsistence standard of 
living. 

Revenue Effect 

[Fiscal years, billions of dollars] 
Proposal 1988 1989 1990 1988-90 

a. Increase in coal excise tax 0.3 0.3 0.3 0.8 

b. Inclusion of black lung cash 

benefits in gross income 0.1 0.2 0.2 0.5 



2. Repeal of Current Gasohol, Bus, and State and Local Govern- 
ment Highway Excise Tax Exemptions 

Present Law 

Revenues from excise taxes on motor fuels, tires, and trucks and 
trailers, and a use tax on heavy highway vehicles are deposited in 
the Highway Trust Fund. Trust Fund monies are used to finance 
authorized expenditures from the Highway Trust Fund. These 
Highway Trust Fund excise taxes are scheduled to expire after Sep- 
tember 30, 1993. Exemptions from all or part of some of these 
excise taxes are provided for fuels containing alcohol, for private 
and public bus operators, and for State and local governments. 

Alcohol fuels. — An exemption of 6 cents per gallon is provided 
for gasohol blends (i.e., 10 percent pure alcohol) of diesel, gasoline, 
and special motor fuels. (The current Highway Trust Fund tax rate 
is 15 cents per gallon for highway diesel fuel and 9 cents per gallon 
for gasoline and special motor fuels.) A 6-cents-per-gallon exemp- 
tion also is provided for neat methanol and ethanol fuels which 
contain at least 85-percent alcohol produced from a substance other 
than petroleum or natural gas. A 4-1/2-cents-per-gallon exemption 
is available for such alcohol blends produced from natural gas. 
These alcohol fuels exemptions are scheduled to expire after Sep- 
tember 30, 1993. 

Buses. — Private and public bus operators generally are exempt 
from the excise tax on tires. Intercity common carrier buses, school 
buses, and qualified local buses are exempt from the 9-cents-per- 
gallon highway taxes on gasoline and special motor fuels. School 
buses and qualified local buses are also exempt from the 15-cents- 
per-gallon diesel fuel tax. In addition, private intercity buses re- 
ceive a 3-cents-per-gallon refund (or credit) of the 15-cents-per- 
gallon highway diesel fuel tax. No exemption is available for buses 
engaged in transportation that is not scheduled and is not along 
regular routes, unless the seating capacity of the bus is at least 20 
adults (not including the driver). 

State and local governments. — Otherwise taxable products or ar- 
ticles used by States and local governments are exempt from all 
Highway Trust Fund excise taxes. 

President's Budget Proposal 

Under the President's budget proposal, the exemptions from 
Highway Trust Fund excise taxes for alcohol fuels, buses, and State 
and local governments would be repealed. 

This proposal would be effective October 1, 1987. 



(15) 



16 

Pros and Cons 
Arguments for the proposal 

1. All users of the Federally financed highway system should 
bear part of the cost of the system. 

2. Exemptions from highway user excise taxes discriminate 
against the tax paying users, and provide a tax subsidy to exempt- 
ed users. 

3. Exemptions from highway user excise taxes deprive the High- 
way Trust Fund of revenues to finance improvements and repairs 
to the system. 

Arguments against the proposal 

1. The exemptions for alcohol fuels encourage utilization of alter- 
nate fuel sources and reduces petroleum usage. 

2. The exemptions for buses encourages greater usage of more 
fuel efficient transportation, thus reducing petroleum usage. 

3. The exemption for State and local governments is part of a 
long standing mutual intergovernmental policy of tax comity with 
respect to excise taxes generally. 

Revenue Effect 

[Fiscal years, billions of dollars] 
Proposal 1988 1989 1990 1988-90 

Repeal of current gasohol, bus, 
and State-local government 
highway excise tax exemp- 
tions 0.2 0.3 0.3 0.8 



3. Airport and Airway Trust Fund Excise Taxes 

Present Law 

Excise taxes are imposed on users of the Federally financed avia- 
tion system. Receipts from these taxes are deposited into the Air- 
port and Airway Trust Fund, and expenditures may be made from 
the Trust Fund for purposes authorized in the Trust Fund statute 
in the Internal Revenue Code. 

The Airport and Airway Trust Fund excise taxes include — 

(1) an 8-percent tax on air passenger transportation; 

(2) a 5-percent tax on domestic air transportation of property; 

(3) a $3-per-person international departure tax; 

(4) a 12-cents-per-gallon tax on gasoline used in noncommercial 
aviation; and 

(5) a 14-cents-per-gallon tax on nongasoline fuels used in noncom- 
mercial aviation. 

Exemptions from the fuels excise taxes have been provided for 
aircraft museums and for certain helicopter uses which do not uti- 
lize the facilities and services of the Federal airport and airway 
system. 

The taxes on air transportation apply to the purchase of trans- 
portation services for persons or property beginning before January 
1, 1988. The taxes on noncommercial aviation fuels expire after De- 
cember 31, 1987. 

President's Budget Proposal 

The President's budget proposal would extend the present-law 
airport and airway system excise taxes for two additional years 
(i.e., through December 31, 1989), and would provide a two-year re- 
authorization of the Airport and Airway Trust Fund programs (for 
fiscal years 1988-1989). 

Other Possible Proposals 

1. The present-law airport and airway excise taxes could be ex- 
tended for 5 years, i.e., through December 31, 1992. (H.R. 2310, as 
approved by the House Committee on Public Works and Transpor- 
tation on June 3, 1987, would provide a 5-year extension of the 
trust fund program authorizations, for fiscal years 1988-1992.) 

2. The air passenger ticket tax could be increased from 8 percent 
to 10 percent, with the additional revenue to go into the general 
fund. Also, corresponding increases could be made in the air cargo 
tax and the international departure tax, with the additional reve- 
nues to go into the general fund. 



(17) 



18 

Pros and Cons 
Arguments for the proposals 

1. The present-law airport and airway taxes should be extended 
to conform to the extension of the Trust Fund program authoriza- 
tions. 

2. Extension of the Trust Fund taxes is needed in order to pre- 
vent a reduction in net budget receipts (as CBO includes them in 
the baseline budget). 

3. In a time of budget stringency, and if other specific excise 
taxes are to be increased, it is appropriate also to increase the air 
passenger and air cargo excise taxes for the budget deficit reduc- 
tion effort. Increases in such excises are less regressive than for 
other Federal excise taxes. 

Arguments against the proposals 

1. Revenues from the aviation excise taxes should be reserved 
(and earmarked as under present law) for the Airport and Airway 
Trust Fund programs, as these taxes represent user charges for 
payment of Federal airport and airway system costs; thus, the 
taxes should be considered separately in the context of the pro- 
posed extension of the trust fund program authorizations. Any po- 
tential increase in such aviation excise taxes should be earmarked 
for needed expansion of the national aviation system and related 
air safety programs rather than for general revenues. 

2. Increasing the aviation excise taxes could adversely affect the 
air passenger and air cargo industry. 

Revenue Effect 

[Fiscal years, billions of dollars] 



Proposal 1988 1989 1990 1988-90 



a. Extend present excise taxes (*) (*) (*) (*) 

b. Increase air ticket tax to 10% 
and corresponding increases 
in the air cargo and departure 

taxes to $— 0.6 0.7 0.7 1.9 



* Extension of present-law trust fund taxes do not result in any net increase in 
estimated budget receipts (included in CBO's baseline budget). 



4. Imposition of Air and Ship Travel Tax 

Present Law 

Present law imposes no general excise tax on international 
travel to and from the United States. A $3 per person international 
departure tax is imposed, however, as part of the funding for the 
Airport and Airway Trust Fund, applicable to certain international 
departure flights exempt from the 8-percent domestic passenger 
ticket tax. {See 3., above.) 

President's Budget Proposal 

The President's budget proposes to impose an excise tax of $1 per 
ticket for international travel to and from the United States, its 
possessions, and its territories by airline or cruise ship carriers. 
Travel to and from Canada, Mexico, and travel to the United 
States that originates in U.S. possessions and territories would be 
exempt from the tax. 

Revenue from this tax would be used to support international 
tourism and marketing activities, defined to include planning, de- 
veloping and carrying out programs to stimulate and encourage 
foreigners to travel in the United States. The proposal would fund 
the $12 million annual budget of the U.S. Travel and Tourism Ad- 
ministration; any revenues collected in excess of the existing 
USTTA budget would go into the general fund of the Treasury. 

This proposal would be effective January 1, 1988. 

(On June 9, 1987, the House Appropriations Subcommittee on 
Commerce, Justice, State, and the Judiciary approved such a $1 
"fee" on international airline and cruise ship passengers entering 
the U.S. as a part of the Subcommittee's fiscal 1988 appropriations 
bill.) 

Pros and Cons 
Arguments for the proposal 

1. A specific revenue source would provide necessary funding of 
the U.S. Travel and Tourism Administration, which supports pro- 
grams (now funded from general revenues) to encourage foreign 
tourism in the United States. 

2. A tax on international air and ship travel to and from the 
United States would be less regressive than certain other excise 
taxes. 

Arguments against the proposal 

1. The proposed air and ship travel tax would impose an addi- 
tional tax and administrative burden on international travel to and 
from the United States. There is already a $3 per person interna- 

(19) 



20 

tional air passenger departure tax, which goes to the Airport and 
Airway Trust Fund (see above). 

2. The U.S. Travel and Tourism Administration should be funded 
out of general revenues rather than from a new earmarked excise 



Revenue Effect 

[Fiscal years, billions of dollars] 






Proposal 1988 1989 


1990 


1988-90 H 


Imposition of $1 air and ship 
travel tax (i) (^) 


(') 


I 

0.1 i 




^ Gain of less than $50 million. 







5. Repeal of Crude Oil Windfall Profit Tax 

Present Law 

Present law imposes an excise tax (the "crude oil windfall profit 
tax") on the windfall profit element of the price of domestically 
produced crude oil when it is removed from the premises on which 
it was produced. Generally, the windfall profit element is the 
excess of the sale price over the sum of an adjusted base price plus 
the applicable State severance tax adjustment. The windfall profit 
element may not exceed 90 percent of net income attributable to a 
barrel of crude oil. 

The tax rates and recent base prices applicable to taxable crude 
oil are as follows: 



Tax rate 



Estimated 
base 



Category of Oil (nercent) P"*=* ' 

^percent) (dollars 

per barrel) 

Tier 1 Oil (oil not in tiers 2 or 3): 

Integrated producer 70 $18.85 

Independent producer 50 19.44 

Tier 2 Oil (stripper and petroleum reserve 
oil): 

Integrated producer 60 21.29 

Independent producer 30 NA 

Tier 3 Oil: 

Newly discovered oil 2 22.5 28.54 

Incremental tertiary oil 30 28.07 

Heavy oil 30 23.91 

1 Estimate for third quarter of 1987 based on SOI Bulletin (Summer 1986). Tier-1 
oil excludes North Slope oil. 

2 Phases down to 20 percent in 1988 and 15 percent in 1989 and subsequent 
years. 

Independent producer stripper well oil is exempt from the tax. 
Additionally, crude oil from a qualified governmental or a qualified 
charitable interest, certain front-end oil, certain Indian oil, certain 
Alaskan oil and, in the case of qualified royalty owners, up to three 
barrels per day of royalty production, are exempt from the tax. 

The windfall profit tax is scheduled to phase out over a 33-month 
period, beginning January, 1991, or earlier if revenues from the tax 
exceed a specified amount. 



(21) 



22 

President's Budget Proposal 

The President's budget proposal would repeal the crude oil wind- 
fall profit tax. 
The proposal would be effective October 1, 1987. 

Pros and Cons 
Arguments for the proposal 

1. At present price levels, the tax raises little or no revenue, yet 
producers must nevertheless incur the burdensome recordkeeping 
expenses associated with the tax. Based on the Congressional 
Budget Office's most recent forecast of petroleum prices, the wind- 
fall profit tax will raise little or no revenue over the next five 
years. 

2. The windfall profit tax discourages exploration and production 
of domestic oil. The windfall profit tax is in effect a sales tax on 
domestic crude oil which cannot be passed on by the producer since 
the price of petroleum is set by foreign producers who are not sub- 
ject to the tax. As a result of the tax, high-cost oil may not be pro- 
duced, and exploration activities may be reduced. 

3. The inflation-adjusted price of oil is now less than half of what 
it was when the Crude Oil Windfall Profit Tax Act was enacted. 
This change in circumstances justifies major change or repeal of 
the Act. 

Arguments against the proposal 

1. The price of oil is extremely volatile and past attempts to pre- 
dict future oil prices have been fraught with error. Forecasters 
failed to foresee the rapid rise in petroleum prices following the Oc- 
tober 1973 war and the rapid fall in petroleum prices in 1986, The 
unpredictable nature of oil prices suggests that revenue estimates 
of the windfall profit tax should be viewed with caution. An unfore- 
seen crisis in the Middle East could send the world market price of 
oil soaring: in this event, repeal of the tax could result in a sub- 
stantial revenue loss to the Federal government and a substantial 
windfall to oil producers. 

2. The windfall profit tax minimizes adverse effects on explora- 
tion and development by setting higher base prices and lower tax 
rates for newly discovered, incremental tertiary, heavy, and strip- 
per well oil. 

3. In April of 1979, the Carter Administration announced that it 
would use its discretionary authority over oil prices to phase out 
price controls between June 1, 1979, and September 30, 1981. Mem- 
bers of Congress who favored price controls did not seek legislation 
against decontrol in return for Administration support for a tax on 
a portion of the profits attributable to decontrol. The Crude Oil 
Windfall Profit Tax Act of 1980 is a result of this compromise. 
Repeal of the tax would breach the compromise reached in 1980. 



23 
Revenue Effect 



[Fiscal years, billions of dollars] 




Proposal 1988 1989 


1990 1988-90 


Repeal of windfall profit tax (*) (*) 


(*) (*) 




* Under current oil price projections, no windfall profit tax 
collected under present law for this period. 


revenues would be 



74-267 0-87-2 



C. PBGC Premiums 
Present Law 

Under present law, if a defined benefit pension plan is terminat- 
ed by a sponsoring employer with assets insufficient to pay benefits 
guaranteed by the Pension Benefit Guaranty Corporation (PBGC), 
then the PBGC pays the monthly benefits required by the particu-[ 
lar plan, up to the guaranteed levels. Subject to certain dollar! 
limits, the PBGC guarantees nonforfeitable retirement benefits! 
other than those that become nonforfeitable on account of the ter-jj 
mination of the plan. ^ i 

Under the Single-Employer Pension Plan Amendments Act of' 
1985 (SEPPA), the sponsor of a single-employer defined benefit 
plan may terminate the plan only in a standard termination or a 
distress termination. A standard termination occurs when the 
assets in the plan are sufficient to pay all benefit commitments. 
Benefit commitments generally include all benefits guaranteed by 
the PBGC and all benefits that would be guaranteed but for the in- 
surance limits on the amounts or value of the benefits. In a stand- 
ard termination, the plan sponsor has no further liability to the 
PBGC after plan termination. 

A distress termination occurs in certain cases of financial hard- 
ship, such as bankruptcy, the inability of the sponsor to pay its 
debts when due unless the plan is terminated, or if pension costs 
become unreasonably burdensome due to a declining workforce. In 
the case of a distress termination, the sponsor continues to be 
liable to the PBGC for the sum of (1) the total amount of all un- 
funded guaranteed benefits, up to 30 percent of the employer's net 
worth, (2) an amount equal to the excess (if any) of (a) 75 percent of 
the total amount of all unfunded guaranteed benefits over (b) the 
amount described in (1), and (3) interest on the amount due calcu- 
lated from the termination date. 

PBGC revenues include per-participant annual premiums with 
respect to defined benefit pension plans, earnings on investments, 
and collections from sponsors of terminated plans. Single-employer 
plans currently pay an annual premium of $8.50 per participant 
(up from $2.60 prior to 1986). The PBGC has limited authority to 
impose a variable rate premium. 

Despite the 1986 increase in the premium rate and the SEPPA 
restrictions on the circumstances under which employers may ter- 
minate underfunded pension plans and shift pension liabilities to 
the PBGC, the termination of underfunded pension plans increased 
the PBGC's deficit from $1.3 billion as of September 30, 1985, to 



' Present law requires that all benefits become nonforfeitable when a pension plan is termi- 
nated. 

(24) 



25 

$3.8 billion as of September 30, 1986. Cash payments to retired 
workers are estimated to exceed PBGC income in 1988. 

President's Budget Proposal 

The President's budget proposal would authorize the PBGC to 
charge higher premiums to those employers who do not adequately 
fund their pension promises. 

The President's proposal provides that the annual premium pay- 
able by a single-employer plan would consist of two main elements. 
Under the proposal, one element would consist of a minimum flat 
per-participant charge applicable to all single-employer plans. The 
flat per-participant charge would be indexed annually for inflation. 
The other proposed element would be a variable-rate funding 
charge based on the excess of a funding target over the level of 
plan assets. The proposal provides that the total of these two pre- 
mium elements would not exceed a maximum of $100 per partici- 
pant for the 1988 plan year. The $100 annual limit would be in- 
dexed. 

The President's budget proposal provides that the funding charge 
rate would be reviewed at 3-year intervals and would be revised 
without the need for Congressional action. Under the proposal, the 
$100 limit on per-participant premiums would be indexed to 1.5 
times the rate of wage growth. 

The President's budget proposal also provides that a surcharge 
would be imposed for missed contributions (e.g., contributions for 
which a funding waiver has been granted). The surcharge would be 
equal to a percentage of the funding charge otherwise due. The 
surcharge would not be taken into account in applying the annual 
limit on per-participant premiums ($100 for the 1988 plan year). 

The proposal would be effective January 1, 1988. 

Pros and Cons 
Arguments for the proposal 

1. The proposed variable-rate premium is more equitable than 
the flat rate premium provided by present law. It would place the 
greatest burden on those employers whose plans present the great- 
est risk of potential loss to the PBGC. 

2. A variable-rate premium would encourage more responsible 
funding of pension benefits. Employers would rather make contri- 
butions to their plans than pay premiums to the PBGC. 

3. A flat-rate premium increase of the magnitude needed to fund 
anticipated liabilities of the PBGC could encourage the termination 
of well-funded plans because employers who have funded responsi- 
bly could incur a significant increase the per-participant cost of 
maintaining their plans without a corresponding increase in bene- 
fits. 

4. A triennial review of the variable-rate element of the premium 
would provide advance assurance to employers that premiums will 
be adjusted to reflect changes in risk. 

Arguments against the proposal 

1. A variable-rate premium structure could unduly burden finan- 
cially distressed plans and employers. The premium should not be 



26 I 

determined under strict insurance principles because of the need to i 
encourage pension plans. 

2. A variable-rate premium could have the effect of diverting 
funds from plans to the PBGC. The cost of paying premiums could 
force the premature termination of a plan and benefit loss for par- 
ticipants. 

3. The premium proposed by the President does not appropriate- 
ly measure the PBGC's risk with respect to a plan because it does 
not measure the financial condition of the employer who maintains 
the plan. Further, it fails to measure appropriately the PBGC's 
risk because it reflects a plan's termination liability, rather than 
its liability for benefits guaranteed by the PBGC. Under the pro- 
posal, a plan with assets that are more than sufficient to pay for 
all guaranteed benefits could, nevertheless, be required to pay an 
additional premium charge based on the plan's funding level. 

4. The premium paid to the PBGC should be regarded as a tax 
because benefits under a plan are guaranteed by the PBGC wheth- 
er or not the premium has been paid. It is not appropriate for the 
Congress to delegate to an administrative agency the determina- 
tion of tax rates. 

Revenue Effect 

[Fiscal years, billions of dollars] 
Proposal 1988 1989 1990 1988-90 

PBGC premiums (negative 
outlay) 0.3 0.3 0.2 0.8 



D. Certain New User Fees 

1. Internal Revenue Service 

Present Law 

The Internal Revenue Service (IRS) currently does not charge 
taxpayers for issuing determination letters or private ruling let- 
ters. In 1984, the IRS issued 106,353 advance determination letters 
on the qualification of corporate and self-employed pension plans, 
and acted on 69,613 applications and ruling requests from tax- 
exempt organizations. The IRS also issued 34,246 private ruling let- 
ters in response to taxpayers' requests during 1984. 

President's Budget Proposal 

The President's budget proposes to impose user fees for each de- 
termination letter and private ruling letter issued by the IRS. The 
level of the fees is not specified. These fees are proposed to become 
effective on October 1, 1987. 

Pros and Cons 
Argument for the proposal 

The Federal Government in recent years has expanded its reve- 
nue base by imposing so-called "user fees" for many government 
services. Currently, the IRS devotes considerable time and man- 
power to the preparation of determination letters and private 
letter rulings. The relatively small number of taxpayers who utilize 
these services should more directly pay these costs. 

Argument against the proposal 

It is inappropriate to impose a user fee on a taxpayer seeking an 
IRS determination or private letter ruling to adequately fulfill his 
legal responsibility to pay taxes. This situation is to be contrasted 
with an individual paying a user fee to visit a national park is gen- 
erally acting voluntarily, rather than seeking to fulfill his legal re- 
sponsibilities. 

Revenue Effect 

[Fiscal years, billions of dollars] 
Proposal 1988 1989 1990 1988-90 

Internal Revenue Service fees ^ ... 0.1 0.1 0.1 0.2 

^ The amount of revenues to be collected is directly linked to the level of the 
user fees. Because no level of user fees has yet been specified, it is assumed that 
the level will be set to collect approximately $0.1 billion annually (as indicated in 
the President's fiscal year 1988 budget). 

(27) 



2. Bureau of Alcohol, Tobacco, and Firearms 

Present Law 

The Treasury Department's Bureau of Alcohol, Tobacco, and 
Firearms (BATF) collects licensing fees and excise taxes on various 
types of firearms, pursuant to the Federal Gun Control Act (19 
U.S.C. sec. 921 et seq.) and the Internal Revenue Code. 

The Code imposes occupational t£ixes on brewers and on whole- 
sale and retail dealers in liquor, wine and beer. The amount of 
these taxes ranges from $24 per year for retail beer dealers to $255 
per year for wholesale liquor and wine dealers. BATF generally 
does not charge fees for permits related to alcohol and tobacco 
products. 

President's Budget Proposal 

The President's budget proposes increasing fees for services pro- 
vided by BATF. These may include an increase in firearms licens- 
ing fees; imposition of fees for permits to produce alcoholic bever- 
ages (pursuant to the Federal Alcohol Administration Act), to 
engage in certain industrial uses of alcohol and to procure or use 
certain tax-free^ or specially denatured distilled spirits; and imposi- 
tion of licensing fees for occupations presently covered by alcohol 
occupational taxes. Similar fees would also be imposed on tobacco- 
related permits. 

This proposal would be effective October 1, 1987. 

Pros and Cons 
Argument for the proposal 

It is appropriate for BATF to charge special fees for firearms li- 
censing, permission to produce alcoholic beverages, engage in cer- 
tain industrial uses of alcohol, procuring or using certain tax-free 
or specially denatured distilled spirits, as well as charging fees for 
tobacco-related permits. Such fees would help offset the BATF cost 
of providing these regulatory services. 

Argument against the proposal 

Regulatory functions performed by BATF should continue to be 
funded from general revenues rather than specific fees. Revenues 
from the alcohol and tobacco excise taxes go into the general fund 
and therefore help support general governmental functions, includ- 
ing BATF administrative and regulatory efforts. 



^ Tax-free uses covered by this provision include certain uses by State or local governments or 
for specified nonbeverage purposes (including laboratory and hospital uses). 

(28) 



29 
Revenue Effect 

[Fiscal years, billions of dollars] 



Proposal 


1988 


1989 


1990 


1988-90 


Bureau of Alcohol, Tobacco and 
Firearms fees 


0.1 


0.1 


0.1 


02 

















3. Customs Service 

Present Law 

As enacted in the Omnibus Budget Reconciliation Act of 1986, an 
ad valorem user fee is applied to all formal entries of merchandise 
imported for consumption in the amount of 0.22 percent during 
fiscal year 1987, dropping to 0.17 percent in fiscal year 1988, and 
expiring after September 30, 1989. The fee does not apply to arti- 
cles classifiable in schedule 8 of the Tariff Schedules (including 
products containing U.S. components which are classifiable in item 
807.00 of the Schedules). 

President's Budget Proposal 

The President's budget proposal would eliminate the exemption 
for articles containing U.S. components and would extend the fee 
beyond its scheduled expiration date. 

The proposal would be effective July 1, 1986. 

Pros and Cons 
Arguments for the proposal 

1. As a user fee, the customs ad valorem fee should be applied to 
all merchandise imported into the United States, rather than ex- 
empting certain articles. 

2. Removal of the exemption would lessen the administrative 
burden of determining and valuing such exemption. 

3. Making the Customs user fee permanent would remove uncer- 
tainty concerning its future application. 

4. Elimination of the exemption would close off an avenue for a 
potentially significant loss of revenues. 

5. Extension of the fee beyond fiscal year 1989 would help to 
reduce the out-year budget deficits by ensuring that the costs of 
customs operations are offset. 

Arguments against the proposal 

1. Applying the user fee to products containing U.S. components 
would increase the cost of such U.S. components. 

2. The Customs user fee should not be made permanent at this 
time, to give the Congress sufficient time to review its impact and 
the appropriate level of the fee. 

3. Importers who take advantage of the schedule 8 exemption 
may be adversely affected by the administrative burden imposed by 
this change. 



(30) 



31 

Possible Other Proposal 

The ad valorem customs user fee could be frozen at 0.22 percent 
for fiscal year 1988 and subsequent years. 

Pros and Cons for Other Proposal 
Argument for the proposal 

Actual receipts for fiscal year 1987 at 0.22 percent are roughly 
equivalent to the cost of Customs' commercial operations, whereas 
the scheduled reduction in the fee level to 0.17 percent will not be 
sufficient to offset the rising commercial costs of the Customs Serv- 
ice. 

Argument against the proposal 

Importers have assumed that the fee would be reduced in fiscal 
year 1988 and may be adversely affected by freezing the fee at a 
higher level. 

Revenue Effect 

[Fiscal years, billions of dollars] 
Proposal 1988 1989 1990 1988-90 

Customs Service user fees: 

a. President's proposal. 0.1 0.2 0.6 0.9 

b. Freeze fee at 0.22% and 
repeal schedule 8 exemp- 
tion 0.1 0.3 0.8 1.4 

c. Repeal schedule 8 exemp- 
tion 0.1 0.2 (1) 0.3 

^ Gain of less than $50 million. 



4. Coast Guard 

Present Law 

The Coast Guard provides various services to recreational and 
commercial boaters, including inspections, licenses, navigation aids, 
and search and rescue operations. These services are funded from 
general revenues. 

President's Budget Proposal 

The President's budget proposes a phased implementation of user ' 
fees for certain Coast Guard services. According to the proposal, 
fees for direct, transactional services (e.g., issuing licenses) would 
be set so as to recover the actual cost of providing the service. Ad- 
ditional fees would be set in proportion to the Coast Guard's cost of 
providing the service to each class of users (e.g., recreational, com- 
mercial fishing, and deep-sea and inland commercial users). 

No fees would be charged for core governmental functions car- 
ried out by the Coast Guard (e.g., defense, law enforcement, and 
polar ice operations). 

The user fee schedule that has been proposed for the Coast 
Guard includes an annual fee schedule for various vessels and 
other fees relating to licensing, inspections and documentation. The 
proposed fee schedule would provide that the receipts from the 
user fees are to be deposited in the general fund o. the Treasury as 
proprietary receipts of the department in which the Coast Guard is 
operating, and would ascribe those receipts to Coast Guard activi- 
ties. 

Vessel fees.— A summary of the annual vessel fee schedule fol- 
lows. 

PROPOSED ANNUAL FEES FOR VESSELS 



Recreational boat $37 

Inland tug 1,000 plus $5 per horsepower 

Fishing vessel 750 plus $7.70 per ton over 

tons 

Mobile drilling unit 2,000 

Coastwise tug 1,000 plus $5 per horsepower 

Coastwise vessel 1,000 plus $1.75 per ton over 



International vessel 552 



tons per arrival 



Port and environmental safety fee schedule.— Proposed fees range 
from $36 for a hot work permit to $550 for reception facility inspec- 
tions. 



(32) 



33 

Documentation of vessels. — Proposed fees range from $170 for ini- 
tial certificate of documentation to $50 for certificate renewal. 
Vessel inspection. — Proposed fees include — 

(1) Initial inspection — from $1,000 plus $50 per gross ton for 
a small passenger vessel to $25,500 for a large passenger 
vessel. 

(2) Inspection for certification — from $225 for an unmanned 
fixed platform to $4,080 for a nautical school ship. 

(3) Reinspection — from $225 for fixed platforms to $2,040 for 
a liquid natural gas carrier, tank vessel, and bulk carrier of 
75,000 tons or over. 

(4) Drydock examinations — from $250 for a small passenger 
vessel to $3,825 for a tank vessel and bulk carrier of 75,000 
gross tons or over. 

Merchant vessel personnel. — Proposed fees range from $200 for is- 
suing a license to $75 for a license renewal. 
Effective date. — This proposal would be effective October 1, 1987. 

Pros and Cons 
Arguments for the proposal 

1. The proposed fees would defray the expenses incurred by the 
Coast Guard in providing clearly identifiable services directly to 
beneficiaries. 

2. The fees would be designed to recover the costs of providing 
services to recreational boaters, commercial fishing, and deep-sea 
and inland commercial operators. User fees would not be used to 
recover the costs of activities that provide benefits to the general 
public, such as, defense preparedness, law enforcement, and polar 
icebreaking operations. 

3. By substituting user fees for general fund financing of these 
Coast Guard activities, inefficient trsmsportation subsidies would be 
eliminated, and the general taxpayer would not subsidize some- 
other individual's recreational or business activities. 

Arguments against the proposal 

1. It is not always possible to identify all the private beneficiaries 
of governmental services, and thus the government may erect com- 
petitive obstacles that affect some but not all competitors. 

2. There may be substantial disagreement about whether a serv- 
ice or activity of the Coast Guard should be considered within a 
fee-for-service context; for example, navigational aids are used by 
the armed services as well, and once installed for their use, there is 
little or no additional cost to the Coast Guard in allowing commer- 
cial fishermen and shippers and recreational boaters to use the 
same navigational aids. 

3. Some of the proposed user fees may not be within the jurisdic- 
tion of the Committee on Ways and Means. 



34 
Revenue Effect 

[Fiscal years, billions of dollars] 



Proposal 1988 1989 1990 1988-90 

Coast Guard user fees 0.4 0.5 0.5 1.3 



II. OTHER POSSIBLE REVENUE OPTIONS 
A. Excise Taxes 
1. Alcoholic Beverage Excise Taxes 

Present Law 

Under present law, excise taxes are levied on the production or 
importation of the three major types of alcoholic beverages: dis- 
tilled spirits, wine, and beer. Also, occupational taxes are imposed 
on certain persons involved with the production or marketing of al- 
coholic beverages. The excise tax on distilled spirits was increased 
by $2.00 per proof gallon in 1984 (the only increase since 1951). The 
excise taxes on wine and beer were last increased in 1955. 

The following is a summary of the excise taxes currently imposed 
on alcoholic beverages: 

Beverage Tax imposed 

Distilled spirits $12.50 per proof gallon 

Beer $9.00 per barrel generally ^ 

Still wines: 

Up to 14 percent alcohol $0.17 per wine gallon 

14 to 21 percent alcohol $0.67 per wine gallon 

21 to 24 percent alcohol ^ $2.25 per wine gallon 

Champagne and sparkling wines $3.40 per wine gallon 

Artificially carbonated wines $2.40 per wine gallon 

^ $7 per barrel for certain small brewers. 

^ Wines containing more than 24 percent alcohol are taxed as distilled spirits. 

For example, the Federal excise tax on a one-fifth gallon bottle of 
80-proof liquor is $1.05; on a six-pack of beer, approximately $0.16; 
and on a 750-milliliter bottle of still wine (less than 14 percent alco- 
hol), about $0.03. 

Possible Proposals 

1. The alcoholic beverage excise tax rates could be doubled. 

2. The tax rates in possible proposal 1 could be indexed for infla- 
tion, using the CPI. 

3. The excise tax rates on wine and beer could be based on alco- 
hol content (like the present distilled spirits tax), and at the 
present-law distilled spirits tax rate. 

4. The distilled spirits tax rate could be doubled, with wine and 
beer tax rates also being based on alcohol content and being im- 
posed at the increased distilled spirits tax rate. 

(35) 



36 

5. The wine tax rates could be increased to equivalent rates to 
the present-law tax imposed on beer. 

6. The beer tax rate could be doubled, and the wine tax rates in- 
creased to equivalent rates to the new tax imposed on beer. 

7. The alcoholic beverage tax rates could be increased by 50 per- 
cent, 

8. The reduction of the tax rate on alcohol content in distilled 
spirits that is attributable to wine or certain flavors could be re- 
pealed. 

Pros and Cons 
Arguments for the proposals 

1. The present alcoholic beverage excise taxes are imposed at flat 
rates rather than being adjusted to reflect inflation. Despite the 
1982 increase in the distilled spirits excise tax rate (the only in- 
crease since 1951), the effective rate of all of the alcoholic beverage 
excise taxes is less than it was in 1951 (distilled spirits) or in 1955 
(wine and beer). For example, had the distilled spirits tax rate been 
indexed to the CPI in 1951, the present tax would be approximately 
$44.00 per proof gallon instead of $12.50 per proof gallon. Similarly, 
the taxes on wine and beer would be significantly higher. Increases 
in these taxes, therefore, are appropriate. 

2. While excise taxes generally are viewed as affecting the poor 
more than the wealthy, i.e., as regressive, the alcoholic beverage 
excise taxes are imposed on discretionary purchases. Arguments 
against regressive taxes are less persuasive in the case of taxes im- 
posed on discretionary purchases than in the case of taxes affecting 
necessities. 

3. From a public policy perspective, alcoholic beverage excise 
taxes are appropriately imposed on alcohol content. Additionally, 
the three major types of alcoholic beverages are substitutes for 
each other and should be taxed at equivalent rates. 

4. The Administration has proposed user fees to offset costs of ad- 
ministering programs of the Bureau of Alcohol, Tobacco, and Fire- 
arms. Increasing the alcoholic beverage excise tax rates is a possi- 
ble alternative means of accomplishing this Administration propos- 
al. 

5. Alcohol-related deaths run as high as 100,000 per year. Esti- 
mated annual costs for business associated with alcohol abuse were 
as high as $113 billion in 1979, with two-thirds of the costs being 
productivity losses of workers. Studies have shown that increases 
in the alcoholic beverage taxes could have a substantial impact in 
reducing consumption. ^ 

Arguments against the proposals 

1. Excise taxes imposed at flat rates cost the poor a larger per- 
centage of disposable income than the relative income share of 
wealthier individuals. According to a 1987 CBO study of excise 
taxes, alcohol expenditures are 10 times higher as a percentage of 



' Cook, Philip J., "The Economics of Alcohol Consumption and Abuse," Alcoholism and Relat- 
ed Problems, 1984; and Impact of Alcohol Excise Tax Increases on Federal Revenues, National 
Alcohol Tax Coalition, 1984. 



37 

income for the ten percent of the families with the lowest income 
than the percentage for the ten percent of families with the high- 
est incomes. 

2. Indexing the alcoholic beverage excise tax rates could lead to 
market distortions as the tax rates changed annually. Prevention 
of such distortions would require imposition of floor stocks taxes ^ 
whenever significant tax increases occurred. Floor stocks taxes 
may impose administrative burdens on retail and wholesale dealers 
in taxable articles. 

3. State and local governments impose excise taxes on alcoholic 
beverages. Increasing Federal tax rates could preempt possible tax 
increases at the State and local levels at a time when other Federal 
assistance is being reduced due to Federal deficit problems. 

4. The alcoholic beverage excise taxes represent a burden on one 
industry. Excessive deficits are a broad-based problem; deficit re- 
duction should be accomplished by measures that spread the 
burden across all segments of the economy rather than unduly bur- 
dening a single industry. 

Revenue Effect 

[Fiscal years, billions of dollars] 



Proposal 1 1988 1989 1990 1988-90 



a. Double taxes on all alcoholic bever- 
ages: 

Distilled spirits 2.1 2.3 2.3 6 8 

Beer 1.1 1.2 1.2 3.5 

Wine 0.3 0.3 0.3 1.0 

b. Index alcoholic beverage taxes after 
doubling: 

Distilled spirits 0.1 0.1 0.2 

Beer (2) o.l 0.1 

Wine (2) 0.1 0.1 

c. Increase beer and wine tax rates to 
present distilled spirits rate: 

Beer 3.3 3.4 3.4 10.1 

Wine 1.7 1.8 0.9 5.5 

d. Double distilled spirits tax rate and 
increase wine and beer tax rates to 
increased distilled spirits rate: 

Distilled spirits 2.1 2.3 2.3 6.8 

Beer 7.2 7.4 7.5 22.1 

Wine 3.5 3.6 3.9 11.0 

e. Increase wine tax rate to present 

beer tax rate 0.4 0.4 0.4 1.1 

f. Double beer tax rate and increase 
wine tax rate to increased beer rate: 

Beer 1.1 1.2 1.2 3.5 

Wine 0.8 0.9 0.9 2.6 



^ Floor stocks taxes are special add-on taxes imposed on products held for sale beyond the reg- 
ular point of taxation on the date of a scheduled increase in rate. 



38 I 

Revenue Effect— Continued 

[Fiscal years, billions of dollars] 
Proposal ' 1988 1989 1990 1988-90 

g. Increase alcohol taxes by 50%: 

Distilled spirits 1.2 1.2 1.2 3.7 

Beer 0.6 0.6 0.6 1.8 

Wine 

h. Repeal reduced tax on distilled spir- 
its derived from wine (^) (^) (^) 0.1 

' All proposals except indexing would be effective on October 1, 1987, with 
appropriate floor stocks taxes being imposed. Indexing would be effective on 
January 1, 1989. 

2 Gain of less than $50 million. 



2. Tobacco Products Excise Taxes 

Present Law 

Excise taxes are imposed on cigars, cigarettes, cigarette papers 
and tubes, snuff, and chewing tobacco manufactured in or imported 
into the United States. Substantially all of the revenue from these 
taxes is raised from the tax on "small cigarettes." Small cigarettes 
are cigarettes weighing no more than 3 pounds per thousand. The 
present rate for that tax has been in effect since 1982. 

The following is a summary of the Federal excise taxes imposed 
on tobacco products under present law: 



Article 


Tax imposed 


Cigars: 

Small cigars 

Large cigars 

Small cigarettes ... 

Large cigarettes ... 

Cigarette papers 

Cigarette tubes 

Chewing tobacco 


$0.75 per thousand 

SVa percent of wholesale price, up to 

$20 per thousand 
$8.00 per thousand (16 cents per pack 


of 20 cigarettes) 

$16.80 per thousand 

$0,005 per 50 papers 

$0.01 per 50 tubes 

$0.08 per pound 


Snuff 


$0.24 per pound 


1 T'lifi r»r«iQ<anf fivpia 


Possible Proposals 

o favoo r>n fr»V»ar»r»r> r»rr»Hnr»f« r»r»nlH \\f^ fJniiV»l*iH 



(e.g., small cigarettes could be taxed at $0.32 per pack of 20 ciga- 
rettes, a $0.16 per pack increase). 

2. The flat tax rates in possible proposal 1 could be indexed for 
inflation, using the CPI. 

3. The present excise taxes on tobacco products could be doubled 
as provided in possible proposal 1 and tax could be imposed on 
pipe, etc. tobacco at $0.48 per pound (the new rate that would apply 
to snuff). 

4. The present excise tax rate for small cigarettes could be in- 
creased by 50 percent to $0.24 per pack of 20 cigarettes (an $0.08 
per pack increase) with comparable increases being enacted for all 
other tobacco products. 

5. The present excise tax rate for small cigarettes could be tri- 
pled to $ 0.48 per pack of 20 cigarettes (a $0.32 per pack increase) 
with comparable increases being enacted for all other tobacco prod- 
ucts. 

(39) 



40 

Pros and Cons 
Arguments for the proposals 

1. The present tobacco product excise taxes are imposed at flat 
rates rather than being adjusted to reflect inflation. Despite the 
1982 increase in the cigarette excise tax rates (the only such in- 
crease since 1951), the effective rate of these taxes is lower today 
than it was in 1951. Had the rates been indexed to the CPI in 1951, 
the present cigarette excise tax rate would be approximately 34 
cents per pack of 20 small cigarettes rather than 16 cents. Higher 
tax rates are therefore appropriate. 

2. Indexing the tobacco taxes would retain the real tax burden of 
these taxes as the general price level increases. 

3. While excise taxes generally are viewed as affecting the poor 
more than the wealthy, i.e., as regressive, the tobacco excise taxes 
are imposed on discretionary purchases. Arguments against any re- 
gressive impact of taxes are less persuasive in the case of taxes im- 
posed on discretionary purchases than in the case of taxes imposed 
on necessities. 

4. The Administration has proposed user fees to offset costs of ad- 
ministering programs of the Bureau of Alcohol, Tobacco, and Fire- 
arms. Increasing the tobacco excise tax rates is a possible alterna- 
tive means of accomplishing this Administration proposal. 

5. The U.S. Surgeon General has identified cigarette smoking as 
the single most important source of premature death in the United 
States. At least one study has stated that 30 percent of deaths from 
heart disease and cancer are smoking related.^ Another study has 
estimated additional health care costs of from $12 to $35 billion per 
year and between $27 and 61 billion per year in lost income result 
from smoking.* Increasing tobacco excise taxes is consistent with 
other Federal Government policies to discourage smoking because 
of the associated health hazards. 

Arguments against the proposals 

1. Excise taxes imposed at flat rates are regressive, i.e., they cost 
the poor a larger percentage of disposable income than they cost 
wealthier individuals making the same purchases. According to a 
January 1987 CBO study on the distributional aspects of selected 
Federal excise taxes, individuals with incomes below $5,000 and be- 
tween $5,000 and $10,000 spent 7.89 and 3.33 percent, respectively, 
of income on tobacco purchases. The percentage declines steadily as 
incomes rise, falling to 0.54 percent for individuals with incomes of 
$50,000 or more. 

2. Indexing the tobacco products excise tax rates could lead to 
market distortions as the tax rates changed annually. Prevention 
on such distortions would require imposition of floor stocks taxes ^ 
whenever significant tax increases occurred. Floor stocks taxes 
impose administrative burdens on retail and wholesale dealers in 
taxable articles. 



^ The Distributional Aspects of an Increase in Selected Federal Excise Taxes, Congressional 
Budget Office Staff Working Paper, January 1987. 

■• Chandler, William U., Banishing Tobacco, Washington Worldwatch Institute, 1986. 

^ Floor stocks taxes are special add-on taxes imposed on products held for sale beyond the reg- 
ular point of taxation on the date of a scheduled increase in tax. 



41 

3. State and local governments impose excise taxes on tobacco 
products. Increasing the Federal tax rates could preempt possible 
tax increases at the State and local levels at a time when other 
Federal assistance to such governments is being reduced due to 
Federal deficit problems. 

4. The tobacco excise taxes represent a burden on one industry. 
Excessive deficits are a broad-based problem; deficit reduction 
should be accomplished by measures that spread the burden across 
all segments of the economy rather than unduly burdening a single 
industry. 

Revenue Effect 

[Fiscal years, billions of dollars] 



Proposal ' 1988 1989 1990 1988-90 

a. Double present tobacco excise tax 

rates 3.0 3.1 3.1 9.2 

b. Index tobacco products tax at dou- 
bled rates 3.0 3.3 3.5 9.8 

c. Double present tobacco excise tax 

rates and extend tax to pipe tobacco ... 3.1 3.1 3.1 9.3 

d. Increase present tobacco excise tax 

rates by 50 percent 1.6 1.6 1.6 4.8 

e. Triple present tobacco excise tax 

rates 5.7 5.3 5.8 17.3 

^AU proposals except indexing would be effective on October 1, 1987 with 
appropriate floor stocks taxes being imposed. Indexing would be effective on 
January 1, 1989. 



3. Telephone Excise Tax 

Present Law 
Imposition of tax 

A 3-percent excise tax is imposed on amounts paid for local and 
toll (long-distance) telephone service and teletjrpewriter exchange 
service. The tax is collected by the provider of the service from the \ 
consumer (business and personal service). The tax is scheduled to 
expire after December 31, 1987. (The telephone excise tax was last 
extended for two years (1986 and 1987) in the Deficit Reduction Act ,' 
of 1984 (P.L. 98-369).) 

Exemptions from the telephone excise tax are provided for instal- 
lation charges, certain coin-operated service, news services (except 
local service), international organizations, the American Red Cross, 
servicemen in combat zones, nonprofit hospitals and educational 
organizations, State and local governments, and for toll telephone 
service paid by a common carrier, telephone or telegraph company, 
or radio broadcasting company in the conduct of its business. In ad- 
dition, an exemption is provided for private communications sys- 
tems (e.g., certain dedicated lines leased to a single business user). 

Treasury study of exemptions 

The Omnibus Budget Reconciliation Act of 1986 (P.L. 99-509) re- 
quires the Treasury Department to study the effects of the current 
exemption for private communications systems and the increasing 
incidence of so-called "by-pass" systems in which private businesses 
own and operate their own internal telephone systems rather than 
accessing the taxable systems operated by common carriers. Treas- 
ury also is to report on the appropriateness of other specific 
present-law exemptions from the telephone excise tax. 

The Treasury Department study is to include revenue effects of 
all present-law telephone tax exemptions and descriptions of types 
of persons benefiting from such exemptions. The report is to be 
submitted to the House Committee on Ways and Means and the 
Senate Committee on Finance by June 30, 1987. 

Possible Proposals 

1. The existing three-percent telephone excise tax could be ex- 
tended for three years (through 1990). 

2. The three-percent telephone tax rate could be extended for 
three years, with the rate being increased to 5 percent for cellular 
and other mobile telephone usage. 

3. The telephone excise tax could be increased to four percent for 
three years. 

4. After a one-year extension at the present rate, the telephone 
tax could be phased out by 0.5 percentage points per year. 

(42) 



43 

5, The present exemptions from the telephone tax could be re- 
pealed. 

6. To limit avoidance of tax through private, by-pass telephone 
systems, a 10-percent excise tax could be imposed on all telephone 
equipment (including fiber optic links) and communications satel- 
lites sold to persons for use in a manner not subject to the tele- 
phone excise tax. 

Pros and Cons 
Arguments for the proposals 

1. At the relatively low tax rate in effect in recent years, the 
telephone excise tax is not a heavy burden on individual or busi- 
ness taxpayers, yet taxpayers are accustomed to it and the tax pro- 
vides needed Federal revenues. 

2. The telephone excise tax does not disproportionately burden 
any regions of the country, and it is easily administered and col- 
lected. 

3. The present exemptions from the telephone excise tax may no 
longer be appropriate, as they erode the potential telephone tax 
base and foster inequitable treatment of communications service 
users. 

4. Imposing an excise tax on the sale of telephone equipment to 
persons other than telephone companies for taxable use would help 
eliminate tax-avoidance by private by-pass systems in which no 
common carrier is used. 

Arguments against the proposals 

1. There is no rationale, other than Federal revenue needs, for 
imposition of the telephone excise tax. 

2. Recent FCC decisions have increased monthly access charges 
for all local telephone service. Allowing the tax to expire would 
partially offset those increases. 

3. The cost of telephone service, particularly local service, is a 
necessary expenditure in today's society. As such, it may be inap- 
propriate to impose an excise tax on such expenditures. 

4. Consumer expenditures on telephone service are a relatively 
higher percentage of income for lower income families than for 
higher income families; thus, the tax has a regressive impact ac- 
cording to income levels. 

Revenue Effect 

[Fiscal years, billions of dollars] 
ProposaH 1988 1989 1990 1988-90 

a. Extend present excise tax for three 

years (1988-1990) 1.3 2.3 2.5 6.0 

b. Extend 3% tax with 5% rate for 

mobile telephone usage 1.3 2.3 2.5 6.1 

c. Increase tax to 4% for three years 1.7 3.0 3.3 9.4 

d. Phase out present tax, after one- 
year extension 1.3 2.0 1.8 5.1 



44 
Revenue Effect — Continued 

[Fiscal years, billions of dollars] 



Proposal 1 1988 1989 1990 1988-90 

e. Impose 10% excise tax on equipment 
sold to persons other than common 
carriers 0.4 0.6 0.7 1.7 

1 All proposals would be effective October 1, 1987, and would include floor stocks 
taxes in the case of the excise tax on certain equipment. 



4. Luxury Excise Taxes 

Present and Prior Law 

Federal excise taxes have not been levied on a broad range of 
consumer items, whether or not such items could be called luxury 
items, since enactment of the Excise Tax Reduction Act of 1965. 

Before enactment of the 1965 Act, retail, wholesale, and manu- 
facturers taxes covered many consumer items without any exemp- 
tion of items priced below threshold levels. Examples of the excise 
taxes, which were repealed in 1965 or later legislation, are listed 
below. 

Manufacturers excise taxes 

1. 10-percent tax on automobiles; 8-percent tax on automobile 
parts and accessories. 

2. 10-percent tax on radio sets, television sets, phonographs, 
records, and other analogous items. (The same tax rate also applied 
to self-contained air-conditioning units, cameras, lenses and film, 
and business machines.) 

3. 5-percent tax on film projectors. 

Retail excise taxes 

1. 10-percent tax on jewelry, various precious and semi-precious 
stones, watches, clocks, sterling silver, silver-plated, gold, or gold- 
plated holloware and flatware, and other items. 

2. 10-percent tax on articles made of fur on the hide or pelt, and 
on articles with fur as the most valuable component. 

3. 10-percent tax on toilet preparations (which included cosmetics 
as well as perfumes), handbags, and luggage. 

Possible Proposals 

1. Ad valorem excise taxes could be reimposed on the articles 
that were subject to excise taxes under prior law. 

2. In addition to the prior-law taxes, taxes could be imposed at a 
10-percent rate on the following articles: 

a. Boats and yachts; 

b. China and crystal; 

c. Airplanes, other than those used for the commercial trans- 
portation of passengers or cargo for hire; 

d. Electronic entertainment and recreational devices (e.g., 
VCRs, video cameras, recording tape and other accessories, 
etc.); 

e. Electronic or mechanical coin-operated amusement de- 
vices; and 

f. Social club dues. 

(45) 



46 

3. Thresholds could be established for certain articles, with the 
taxes applying to the excess of price above the established thresh- 
old. For example, the tax on automobiles could apply to the excess 
of the price over $20,000, and the tax on boats and yachts could 
apply to the excess of the price over $15,000. 

Under all three proposals, whether the taxes would be imposed 
at the manufacturer or retail level would be determined based on 
the relative ease of administering each tax. 

Pros and Cons 
Arguments for the proposals 

1. Excise taxes have a direct effect on reducing consumption of 
the taxable items, and thus encourage savings. 

2. Properly targeted, luxury excise taxes would affect wealthier 
individuals to a greater degree as a percentage of disposable 
income than the poor. Inclusion of such taxes in a revenue-raising 
package would help render such a package more progressive in its 
impact. 

Arguments against the proposals 

1. Administrative cost-revenue ratios associated with these excise 
taxes would be very high relative to the cost-revenue ratio of 
income taxes. Relative administrative costs are higher for retail 
excise taxes than for manufacturers excise taxes because of the 
greater number of retailers, and thus a greater number of returns 
to process. However, the determination of price in many transac- 
tions below the retail level is determined on the basis of negotia- 
tions or arbitrary prices set between manufacturers and wholesal- 
ers owned by the same person rather than set prices applicable to 
purchasers generally; taxes levied on such transactions tend to 
create even greater distortions in relative prices. 

2. There are few objective standards available to use in deciding 
which articles are luxury goods. 



47 
Revenue Effect 

[Fiscal years, billions of dollars] 



Proposal 1 1988 1989 1990 1988-90 

a. 10% tax on value of autos in excess 

of $20,000 0.3 0.4 0.4 1.2 

b. 10% tax on value of boats, yachts in 

excess of $15,000 0.1 0.1 0.1 0.3 

c. 10% tax on value of general aviation 

aircraft 0.2 0.3 0.3 0.8 

d. 10% tax on value of furs 0.1 0.1 0.1 0.2 

e. 10% tax on value of consumer elec- 
tronic entertainment products (in- 
cluding TVs, radios, stereo equip- 
ment, VCRs, video cameras, and re- 
lated products) 1.5 2.8 3.0 7.3 

f. 10% tax on value of jewelry and 

precious gemstones in excess of $100... 0.2 0.4 0.4 1.1 

1 All proposEils would be effective on October 1, 1987, with appropriate floor 
stocks taxes being imposed. 



5. Firearms Excise Taxes 

Present Law 

Two manufacturers excise taxes are imposed with respect to fire- 
arms under present law. First, tax is imposed at 10 percent of sales 
price on the sale of pistols and revolvers and at 11 percent of sales 
price on the sale of rifles, shotguns, and ammunition. 

Second, a special $200-per-firearm excise tax is imposed to regu- 
late the production of machine guns, destructive devices (e.g., 
bombs, grenades, mines, etc.) and certain other concealable fire- 
arms. 

Revenues equivalent to the 10-percent and 11-percent excise 
taxes are dedicated to financing of the Federal Aid to Wildlife Pro- 
gram for support of State wildlife programs. 

Possible Proposals 

Both of the present excise taxes on firearms could be doubled. In 
the case of the 10-percent and 11-percent taxes, the additional reve- 
nues could be retained in general revenues rather than being dedi- 
cated to support State wildlife programs. 

Pros and Cons 
Arguments for the proposals 

1. If excise taxes are to be increased for deficit reduction, it is 
appropriate to increase all such taxes, rather than singling out spe- 
cific taxes and industries. 

2. Tax rates have not been increased on pistols and revolvers 
since 1955, and since 1940 in the case of the 11-percent tax on other 
firearms and ammunition. 

Argument against the proposals 

Revenues from certain of these excise taxes historically have 
been dedicated to the Federal Aid to Wildlife program. Because of 
the relatively small amounts of revenue involved, continued dedica- 
tion of all revenues from these taxes to support of wildlife pro- 
grams is appropriate. 

(48) 



49 
Revenue Effect 

[Fiscal years, billions of dollars] 



Proposal 1 1988 1989 1990 1988-90 



Double present firearms taxes 0.1 0.1 0.1 0.3 

1 The proposal would be effective on October 1, 1987, with appropriate floor 
stocks taxes being imposed. 



6. Pollution Excise Taxes 

a. Excise tax on sulfur and nitrogen emissions 

Present Law 

Sulfur dioxide and nitrogen oxide emissions are not taxed under 

present law. 

\ 

Possible Proposal 

An excise tax could be imposed on emission into the atmosphere \ 
of sulfur dioxide and nitrogen oxides from any boiler or furnace 
which is used to burn fossil fuels for steam production. A variable 
rate of tax could be imposed depending on the emissions rate. 

A 25-percent income tax credit, earned ratably over 10 years, 
could be allowed for investment in pollution control equipment. 

Pros and Cons 
Arguments for the proposal 

1. A tax on sulfur dioxide and nitrogen oxide emissions would 
create an incentive for boiler operators to reduce such emissions 
which have been linked to acid rain. 

2. Emissions reductions may be achieved with lower costs to in- 
dustry and government by imposition of an emissions tax as com- 
pared with alternative policies such as power plant emission limita- 
tions. 

Arguments against the proposal 

1. An emissions tax would raise domestic manufacturing costs, 
making it more difficult for U.S. producers to compete with foreign 
producers in both the domestic and world markets. 

2. Taxpayers would be required to calculate on a continuous 
basis taxable emissions of sulfur dioxide and nitrogen oxides. This 
could require costly monitoring or fuel content analysis. 

3. An emissions tax would discourage use of high-sulfur coal. 
This would adversely affect employment and profits in the high- 
sulfur coal mining industry, which is concentrated in Appalachia 
and the midwestern portion of the United States. 

(50) 



b. Tax on ozone depleting chemicals 
Present Law 

Chemicals which deplete the ozone layer are not subject to tax 
under present law. 

Possible Proposal 

An excise tax could be imposed on the sale or use by the manu- 
facturer of ozone depleting chemicals and on the import of such 
chemicals, or products containing such chemicals. Ozone depleting 
chemicals include chlorofluorocarbons ("CFCs") which are used as 
refrigerants, foam blowing agents, and solvents; methyl chloroform; 
carbon tetrachloride; and halon. The tax rate per pound could vary 
according to the ozone depleting potential of the chemical. 

Pros and Cons 
Arguments in favor of the proposal 

1. A tax on ozone depleting chemicals would reduce their produc- 
tion and use in the United States. 

2. U.S. chemical companies would have an incentive to develop 
substitute chemicals that do not deplete the ozone layer. To the 
extent that substitutes are developed, U.S. chemical companies 
may be able to increase domestic market share relative to imports. 

Arguments against the proposal 

1. Unless exports are exempt from tax, domestic manufacturers 
of ozone depleting chemicals would be placed at a competitive dis- 
advantage in the world market relative to foreign producers. 

2. There is scientific controversy over the extent to which CFCs 
and other chemicals contribute to the depletion of the ozone layer. 
Also the amount of ozone depletion caused by any particular chem- 
ical may vary according to its use by the purchaser. 

3. Taxation of imported products containing ozone depleting 
chemicals would be complex to administer. 

(51) 



52 
Revenue Effect 

[Fiscal years, billions of dollars] 



Proposal 1988 1989 1990 1988-90 

a. Sulfur and nitrogen emissions tax of 

45 cents per pound 6.4 6.9 5,7 19.0 

b. Tax on ozone-depleting chemicals 
($1 per pound of CFC-11 or equiva- 
lent in 1988, $2 in 1989, and $3 in 

1990) 0.3 0.5 0.7 1.6 



7. Energy Consumption Taxes 

a. Broad-based energy tax 

Present Law 

Under present law, a variety of excise taxes and tariffs are im- 
posed on the sale, use, or importation of chemical and mineral 
fuels. These include: the Highway, Aquatic Resources, Airport and 
Airway, Inland Waterway, and Leaking Underground Storage 
Tank Trust Fund taxes on gasoline, diesel fuel, and other motor 
fuels; the Superfund taxes on petroleum and certain chemical feed- 
stocks; the Black Lung Disability Trust Fund tax on coal; and the 
tariff on imported crude petroleum and certain petroleum prod- 
ucts. 

Motor fuels taxes 

Excise taxes are imposed on gasoline and special motor fuels (9 
cents per gallon), diesel fuel (15 cents per gallon), aviation gasoline 
(12 cents per gallon), aviation jet fuel (14 cents per gallon), and fuel 
used by inland waterway vessels (10 cents per gallon). Revenues 
from these taxes are dedicated respectively to the Highway (Aquat- 
ic Resources for motorboat fuels). Airport and Airway, and Inland 
Waterway Trust Funds. An additional 0.1-cent-per-gallon tax is im- 
posed on these fuels to finance the Leaking Underground Storage 
Tank Trust Fund. The highway and motorboat taxes are scheduled 
to expire after September 30, 1993; the aviation taxes are each 
scheduled to expire after December 31, 1987; the inland waterways 
tax is scheduled to phase up from 10 cents to 20 cents per gallon 
over the period 1990-1995; and the leaking underground storage 
tank tax expires on December 31, 1991, or earlier if $500 million of 
revenue is collected. 

Superfund taxes 

Receipts from a petroleum tax, a tax on chemical feedstocks, and 
a tax on certain imported substances derived from taxable feed- 
stocks (effective January 1, 1989) are deposited into the Hazardous 
Substance Superfund to pay for the cleanup of hazardous waste 
sites. 

Petroleum tax 

A tax of 8.2 cents per barrel of domestic crude oil and 11.7 cents 
per barrel of imported petroleum products is imposed on the re- 
ceipt of crude oil at a U.S. refinery, the import of petroleum prod- 
ucts and, if the tax has not already been paid, on the use or export 
of domestically produced oil. The petroleum tax expires on Decem- 
ber 31, 1991, or earlier if the Superfund unobligated balance ex- 

(53) 



54 ' 

ceeds a certain level or total Superfund revenues exceed a certain | 
amount. 

Tax on feedstock chemicals ^ 

A tax on feedstock chemicals applies to the sale or use of 42 spec- 
ified organic and inorganic chemicals ("feedstock chemicals") by 
the manufacturer, producer, or importer. The tax rates range from 
22 cents to $4.87 per ton. (A special rate applies to xylene to com- 
pensate for refunds of tax previously paid with respect to xylene.) 
Exports of taxabla chemicals and certain taxable substances made 
from taxable chemicals are exempt from tax. Other exemptions in- 
clude taxable chemicals used to make animal feed, fertilizer, and 
motor fuel. The tax on feedstock chemicals expires on December ' 
31, 1991, or earlier, under the same circumstances as the tax on pe- 
troleum. I 

Tax on certain imported substances 

Certain substances derived from taxable chemical feedstocks are 
subject to tax, when sold or used by the importer, according to 
their taxable chemical content. If the importer does not furnish 
sufficient information to determine the taxable chemical content, a 
5-percent tax is imposed on the customs value of the imported sub- 
stance. The tax on imported substances is effective January 1, 1989, 
and terminates at the same time as the tax on chemical feedstocks. 

Coal tax 

The black lung excise tax on coal is $1.10 per ton in the case of 
coal from underground mines and 55 cents per ton in the case of 
coal from surface mines, or if less, 4.4 percent of the price for 
which the coal is sold. Receipts from this tax are placed in the 
Black Lung Disability Trust Fund to pay benefits to miners who 
suffer from pneumoconiosis or their survivors. On January 1, 1996, 
or earlier under certain circumstances, the tax rates are scheduled 
to return to the pre-1982 rates (i.e., 50 cents per ton for under- ■ 
ground mines and 25 cents per ton for surface mines, limited to 2 
percent of price). \ 

Tariff on imported petroleum | 

A tariff of 0.125 cent per gallon is imposed on crude petroleum, 
topped crude petroleum, shale oil, and distillate and residual fuel 
oils derived from petroleum, with low density (under 25 degrees 
A.P.I.). For substances with higher densities (testing 25 degrees ^ 
A.P.I, or more), the tariff is 0.25 cent per gallon. (Imports from cer- 
tain communist countries are subject to a 0.5-cent-per-gallon tariff, , 
regardless of density.) A 1.25-cents-per-gallon tariff (2.5 cents, for j 
certain communist countries) also is imposed on certain motor fuels ^ 
and a 0.25-cent-per-gallon tariff (0.5 cent, for certain communist ^ 
countries) is imposed on petroleum-derived kerosene and naphthas ^ 
(except motor fuels). Natural gas, together with methane, ethane, ' 
propane, butane, and mixtures thereof may be imported tariff-free. 
Certain Canadian petroleum also may be admitted tariff-free, sub- 
ject to an exchange agreement allowing like treatment for an „ 
equivalent amount of U.S. petroleum imported into Canada. » 



55 

Possible Proposals 

BTU tax 

A tax could be imposed on domestic energy consumption equal to 
a fixed amount per BTU.^ Renewable energy sources like solar and 
wind energy and synthetic fuels could be exempted. If the tax is 
limited to U.S. energy consumption, fuel imports would be subject 
to tax and fuel exports would be exempt. 

Ad valorem energy tax 

A second broad-base energy tax option would be to impose a tax 
on domestic energy consumption according to fuel value. Under 
this alternative, the stage at which the tax is imposed is important 
since value is added to fuels through the refining, processing, 
transportation, and marketing levels. The closer to the wellhead, 
mine mouth, or power plant a particular ad valorem tax is imposed 
on an energy product, the lower will be the receipt from a tax im- 
posed at a particular rate on any product. Utilities could be al- 
lowed a credit for tax paid on fuels used to generate electricity to 
avoid double taxation. 

A variant would be to impose a fixed-rate tax on different fuels 
(e.g., so much per barrel, cubic foot, ton, or kilowatt-hour) designed 
to approximate an ad valorem tax. These tax rates could be adjust- 
ed annually based on fuel price indices. To reduce the number of 
taxpayers, the tax could be imposed at the refinery level in the 
case of petroleum, at the city gate in the case of natural gas, at the 
mine mouth in the case of coal, and at the utility company level in 
the case of electricity. 

If the tax is limited to U.S. energy consumption, fuel imports 
would be subject to tax and fuel exports would be exempt. 

Pros and Cons 
Arguments for the proposals 

1. Energy consumption has various costs which are not reflected 
in energy prices and thus are not taken into account by consumers 
in making decisions about energy consumption. These costs include 
higher prices which must be paid to foreign producers, decreased 
national security associated with high oil import levels, and pollu- 
tion of the environment. Energy consumption taxes would increase 
prices to reflect these costs, and thus would reduce these costs as 
consumption of energy declined. 

2. In many applications, one fuel may be substituted for another, 
such as natural gas for oil to fire a boiler. Thus, increasing excise 
taxes on only one fuel type may cause energy users to switch to 
other fuel sources. By contrast, a broad-base Btu or ad valorem 
energy tax would be relatively neutral with respect to fuel choice, 
and could not be avoided by fuel switching. 



® A BTU, or British thermal unit, is a measure of energy content. One BTU is the amount of 
energy needed to raise the temperature of one pound of water by one degree Farenheit. One 
million BTUs are contained in 975 cubic feet of natural gas, 7.2 gallons of crude oil, 80 pounds of 
coal, or 293 kilowatt-hours of electricity. 



74-267 0-87-3 



56 

3. Taxing all energy consumption rather than only selected 
energy products results in a larger tax base; thus a given amount 
of revenue can be raised, without disproportionate regional bur- 
dens, at a lower rate of tax. 

Arguments against the proposals 

1. Any broad-base tax on energy consumption would increase the 
cost of domestic manufacturers and decrease their ability to com- 
pete with foreign manufacturers in the domestic and world mar- 
kets. Statutory devices to relieve exports from the impact of the 
tax would be difficult to administer. 

2. Energy taxes (like many consumption-based taxes) are regres- 
sive, affecting low-income households relatively more severely than 
high-income households. 

3. There would be high administrative and compliance costs asso- 
ciated with the establishment of a broad-base energy tax which 
would be difficult to justify unless the tax were designed to raise 
substantial revenue. In addition, the complexity of such a tax 
would necessitate a delayed effective date. 

4. If domestic energy products are taxed at the same rate as im- 
ports, there would be no incentive for increased domestic energy 
production. 

Revenue Effect 

[Fiscal years, billions of dollars] 
Proposal 1988 1989 1990 1988-90 

Tax on coal, hydroelectric and nuclear 
power, natural gas and petroleum: 

$0.20 per thousand Btu 9.8 10.3 10.5 30.6 

5 percent of value 12.2 13.8 14.6 40.6 

Note.— Assumes effective date of January 1, 1988. 



b. Broad-based petroleum tax 

Present Law 

Superfund taxes of 8.2 cents per barrel for domestic crude oil and 
11.7 cents per barrel for imported petroleum products are imposed 
on the receipt of crude oil at a U.S. refinery, the import of petrole- 
um products and, if the tax has not already been paid, on the use 
or export of domestically produced oil. 

Domestic crude oil subject to tax includes crude oil condensate 
and natural gasoline, but not other natural gas liquids. Taxable 
crude oil does not include oil used for extraction purposes on the 
premises from which it was produced, or synthetic petroleum (e.g., 
shale oil, liquids from coal, tar sands, biomass), or refined oil. 

Petroleum products which are subject to tax upon import include 
crude oil, crude oil condensate, natural and refined gasoline, re- 
fined and residual oil, and any other hydrocarbon product derived 
from crude oil or natural gasoline which enters the United States 
in liquid form. 

The petroleum tax generally expires on December 31, 1991. The 
tax would terminate earlier than that date if cumulative Super- 
fund receipts during the reauthorization period equal or exceed 
$6.65 billion, and under certain other conditions. 

Possible Proposal 

The Superfund taxes on domestic and imported crude oil and pe- 
troleum products could be increased, with receipts from the in- 
creased tax being deposited in general revenues. 

Pros and Cons 
Arguments for the proposal 

1. A tax on domestic and imported petroleum could be accom- 
plished by increasing the existing Superfund petroleum tax; thus 
start-up and administrative costs would be relatively low compared 
to a new broad-base energy tax (such as the BTU or ad valorem 
energy taxes described above). 

2. A tax on domestic and imported petroleum would encourage 
conservation and thus reduce petroleum imports and import de- 
pendence. 

Arguments against the proposal 

1. A tax on petroleum would increase the costs of domestic man- 
ufacturers and decrease their ability to compete against foreign 
producers in both the domestic and world markets. Statutory de- 
vices to relieve exports from the impact of the tax would be diffi- 
cult to administer. 

(57) 



58 

2. A tax on petroleum would favor natural gas, coal, and nonfos- 
sil fuel energy sources over petroleum, with no incentive for in- 
creased domestic oil production. 

3. A tax on crude oil would raise the price of all petroleum prod- 
ucts. For example, a $1 per barrel import fee would raise the price 
of gasoline by approximately 2.3 cents per gallon. 

4. A tax on petroleum would impose a larger burden on low- 
income households relative to high-income households, since low- 
income households spend a larger portion of their disposable 
income on petroleum products. 

Revenue Effect 

[Fiscal years, billions of dollars] 
Proposal 1988 1989 1990 1988-90 

$1.25-per-barrel tax on all oil consump- 
tion 5.0 5.2 5.2 15.4 

$2.50-per-barrel tax on all oil consump- 
tion 10.0 10.1 10.1 30.1 

$5.00-per-barrel tax on all oil consump- 
tion 19.6 19.1 18.9 57.6 



c. Oil import tax 

Present Law 
Superfund tax on petroleum 

A tax of 8.2 cents per barrel of domestic crude oil and 11.7 cents 
per barrel of imported petroleum products is imposed on the re- 
ceipt of crude oil at a U.S. refinery, the import of petroleum prod- 
ucts and, if the tax has not already been paid, on the use or export 
of domestically produced oil. 

Petroleum products which are subject to tax upon import include 
crude oil, crude oil condensate, natural and refined gasoline, re- 
fined and residual oil, and any other hydrocarbon product derived 
from crude oil or natural gasoline which enters the United States 
in liquid form. 

The petroleum tax generally expires on December 31, 1991. The 
tax would terminate earlier than that date if cumulative Super- 
fund receipts during the reauthorization period equal or exceed 
$6.65 billion, and under certain other conditions. 

Canada, Mexico, and the European Community filed a formal 
complaint under the General Agreement on Tariffs and Trade 
("GATT") after the Superfund tax on imported oil was raised above 
that on domestic oil in the Superfund Reauthorization Act of 1986. 
A GATT panel convened to investigate the complaint concluded 
that the differential petroleum tax rate is contrary to the GATT, 
and the panel ruling was accepted unanimously by the GATT 
Council on June 17, 1987. Under GATT rules, the United States 
either must amend the Superfund tax or compensate the plaintiffs 
to avoid possible retaliatory tariffs. 

Tariff on imported petroleum 

Tariffs are imposed on various categories of articles that are im- 
ported into the customs territory of the United States (including 
the 50 states, the District of Columbia, and Puerto Rico). The tar- 
iffs generally are imposed at a uniform rate on imports from most 
noncommunist countries, with separate, higher rates imposed on 
imports from certain communist nations. Preferential treatment 
applies to certain imports from developing countries, specified Car- 
ibbean basin nations, and Israel. Imports from U.S. insular posses- 
sions, where the imported product is not comprised primarily of 
foreign materials, may be made duty-free. Tariffs are imposed pur- 
suant to the Tariff Act of 1930 (19 U.S.C. sec. 1202 et seq.), and gen- 
erally are subject to GATT limitations. 

At present, a tariff of 0.125 cent per gallon is imposed on crude 
petroleum, topped crude petroleum, shale oil, and distillate and re- 
sidual fuel oils derived from petroleum, with low density (under 25 
degrees A.P.I.). For substances with higher densities (testing 25 de- 

(59) 



60 

grees A.P.I, or more), the tariff is 0.25 cent per gallon.'^ (Imports 
from certain communist countries are subject to a 0.5-cent-per- 
gallon tariff, regardless of density.) A 1.25-cents-per-gallon tariff 
(2.5 cents, for certain communist countries) also is imposed on cer- 
tain motor fuels and a 0.25-cent-per-gallon tariff (0.5 cent, for cer- 
tain communist countries) is imposed on petroleum-derived kero- 
sene and naphthas (except motor fuels). Natural gas, together with 
methane, ethane, propane, butane, and mixtures thereof may be 
imported tariff-free. Certain Canadian petroleum also may be ad- 
mitted tariff-free, subject to an exchange agreement allowing like 
treatment for an equivalent amount of U.S. petroleum imported 
into Canada. 

Import fee authority 

Under the Trade Expansion Act of 1962, the President can 
impose oil import fees or import quotas if he finds that imports 
threaten the nation's security. Congress may roll back such fees by 
passing a joint resolution of disapproval; however, this resolution 
can be vetoed by the President, in which case^ the fees he imposed 
would continue in effect unless the President's veto is overridden 
by a two-thirds vote of both Houses of Coiigress. These procedures 
for Congressional vetoes and overrides wdre specified by the Crude 
Oil Windfall Profit Tax Act of 1980 (P.L. 96-223). 

Under an exemption from the General Agreement on Tariffs and 
Trade (GATT), a tariff imposed on national security grounds is not 
a violation of trade agreements. Consequently, enactment of a 
tariff on imported petroleum for legitimate national security rea- 
sons would not result in the imposition of GATT-authorized coun- 
tervailing duties or other trade penalties. 

The presidential import fee authority was used, to various ex- 
tents, by Presidents Nixon, Ford, and Carter. President Nixon im- 
posed import license fees of 21 cents per barrel for crude oil and 63 
cents on refined products in 1973 (this differential was intended to 
encourage domestic refining). President Ford imposed an additional 
$2-per-barrel crude oil import fee in 1975, but lifted the fee early in 
1976. President Carter raised the possibility of an import fee in 
1977 and again in 1979, in response to which Congress adopted the 
veto and override provisions contained in the Crude Oil Windfall 
Profit Tax Act. (Both the Ford import fee and the original Carter 
proposal were intended to encourage action on broader energy pro- 
posals.) President Carter actually imposed a $4.62 per barrel 
import fee in 1980, with allocation rules that effectively converted 
the fee into a 10-cents-per-gallon gasoline tax. However, a resolu- 
tion of disapproval was passed by the Congress, and President 
Carter's veto of that resolution was overridden. 

Possible Proposals 
Increcse petroleum tariff rates 

The existing tariffs on imported crude oil and petroleum prod- 
ucts could be increased. Alternatively, the Superfund tax on im- 
ported petroleum products could be increased with the additional 



' Degrees API equals 141.5 divided by specific gravity, less 131.5. 



61 

revenue allocated to the general fund of the Treasury. Exemptions 
could be allowed for petroleum used in agriculture, in the manufac- 
ture of exports, and as home heating oil. Imported petroleum prod- 
ucts could be taxed at a higher rate than imported crude oil. 

Impose a floor price on imported petroleum 

An excise tax or tariff could be imposed on imported petroleum 
equal to the excess of a specified floor price over an index of the 
world market price of crude oil. The effect of such a variable 
import fee would be to prevent the domestic price of crude oil from 
falling below the floor price. 

Tax domestic and imported petroleum with a production credit for 
domestic producers 

The Superfund tax on domestic crude oil and imported petroleum 
products could be increased by $5 per barrel, with the proceeds de- 
posited in the general fund of the Treasury. The burden on domes- 
tic producers could be offset in part by a credit equal to the excess 
of $20 over the world market price of oil, up to $5 per barrel. This 
option is equivalent to a $5 per barrel import fee when the world 
oil price is less than $15 per barrel, and is equivalent to a $5 tax on 
both domestic and imported petroleum when the world oil price ex- 
ceeds $20 per barrel. 

Pros and Cons 
Arguments for the proposals 

1. A petroleum import fee would protect domestic oil producers 
from the decline in world oil prices which has occurred over the 
last two years. 

2. Higher oil prices would encourage conservation and domestic 
exploration and production, and would discourage imports and 
abandonment of marginal wells. Reduced import dependence would 
improve the security of U.S. energy supply. 

3. A petroleum import fee would improve the financial situation 
of banks with large portfolios of energy loans. 

4. A variable import fee designed to maintain the domestic price 
of oil above a floor price would tend to stabilize domestic energy 
prices and provide some protection to domestic producers against a 
future collapse in oil prices. The supply of capital to the petroleum 
industry likely would increase as a result of such price protection. 

Arguments against the proposals 

1. A tax on imported petroleum would increase the costs of do- 
mestic manufacturers and decrease their ability to compete against 
foreign producers in both the domestic and world markets. Statuto- 
ry devices to relieve exports from the impact of the tax would be 
difficult to administer. 

2. A tax on imported petroleum would impose a larger burden on 
low-income relative to high-income households, since poorer house- 
holds spend a larger portion of their disposable income on petrole- 
um products. 

3. A tax on imported oil would raise only about one-third of the 
revenue of a tax imposed on both domestic and imported petrole- 



62 

um. Exempting domestic production in effect transfers about two- 
thirds of the potential revenue as a windfall to domestic producers. 

4, A tax or tariff on imported petroleum would adversely affect 
Mexico, Canada, the United Kingdom, and other non-OPEC oil pro- 
ducers who jointly supplied over half of the petroleum imported 
into the United States in 1986. Also, such a tax or tariff would vio- 
late the GATT unless covered by the national security clause. 

5. A variable import fee designed to establish a floor under the 
price of domestic petroleum would fail to raise revenue if the world 
price were to rise above the floor price. 

Revenue Effect 

[Fiscal years, billions of dollars] 
Proposal 1988 1989 1990 1988-90 

Oil import tax: 

$4-per-barrel tax, no exemptions 6.5 5.9 5.9 18.3 

$5-per-barrel tax, no exemptions 8.0 7.0 6.9 21.9 

$5-per-barrel tax on imported 
crude oil, $7.50-per-barrel tax on 
imported refined petroleum 
products 8.6 7.2 7.0 22.8 

Tax equal to the excess of $24 over 
the weighted-average price of 
imported crude oil on all import- 
ed crude and refined petroleum 
products; exemption for petrole- 
um products used in agriculture, 
home heating oil, and in the 
manufacture of products for 
export 12.1 5.7 4.9 22.7 ^ 

Tax equal to the excess of $24 over n 

the weighted-average price of « 

imported crude oil on all import- i 

ed crude and refined petroleum 
products 15.7 9.7 8.7 24.1 

$5-per-barrel tax on imported and 
domestic oil; credit equal to 

excess of $20 over the world ;i 
price of oil for domestic produc- 
tion, limited to $5 8.0 7.0 7.0 21.9 



8. Motor Fuels Excise Taxes 

a. Increase in excise tax rates 

Present Law 

Four separate excise taxes are imposed on gasoline, diesel fuel, 
and special motor fuels under present law. A tax of 9 cents per 
gallon is imposed on gasoline and special motor fuels and a tax of 
15 cents per gallon is imposed on diesel fuel used in highway vehi- 
cles; revenues from these taxes are deposited in the Highway Trust 
Fund. 

Fuels used in commercial aviation (i.e., aviation carrying passen- 
gers or cargo for hire) are exempt from the tax. Fuels used in gen- 
eral aviation are subject to the general motor fuels excise taxes, 
plus a special, add-on tax. Revenues from these taxes on aviation 
gasoline are deposited in the Airport and Airway Trust Fund. 

A tax of 0.1 cent per gallon is imposed on gasoline, special motor 
fuels, and diesel fuel (including such fuel used in nonhighway uses 
such as trains and all aviation gasoline); revenue from this tax is 
deposited in the Leaking Underground Storage Trust Fund (LUST). 

Fuels used in vessels engaged in transportation on specified com- 
mercial inland waterways are subject to a separate excise tax, re- 
ceipts from which are deposited in the Inland Waterways Trust 
Fund. This excise tax presently is 10-cents per gallon, and is sched- 
uled to increase to 20-cents per gallon beginning in 1995. The wa- 
terways fuel tax does not apply to marine water transportation. 

Exemptions from some or all these taxes are provided for fuels 
sold for export, for use by State and local governments, for use by 
nonprofit educational organizations. Fuels used in farming are 
exempt from the Highway Trust Fund taxes. Additionally, a par- 
tial exemption is provided from the Highway Trust Fund taxes for 
certain fuels blended with alcohol. 

The Highway Trust Fund taxes are scheduled to expire after 
September 30, 1993. The LUST taxes are scheduled to expire after 
December 31, 1991, or earlier if revenues from the tax reach a spec- 
ified amount. The Airport and Airway Trust Fund taxes are sched- 
uled to expire after September 30, 1987. 

Possible Proposals 

1. The excise taxes on all motor fuels used in highway uses could 
be increased by 5 cents per gallon or by 10 cents per gallon. 

2. After increasing the motor fuels excise taxes on motor fuels 
used in highway uses as provided in possible proposal 1, the taxes 
could be indexed for inflation using the CPI. 

3. The increases in possible proposal 1 could be limited to gaso- 
line and special motor fuels (i.e., diesel fuel used in highway uses 
would continue to be taxed at 15.1 cents per gallon). 

(63) 



64 

4. Possible proposal 1 could be adopted, with the taxes being ex- 
panded to apply to nonhighway uses (e.g., trains, aviation, and 
shipping) that are subject to the LUST tax. ' 

Pros and Cons 
Arguments for the proposals 

1. Increased motor fuels taxes may reduce domestic consumption 
as a result of increased prices. Reduction in the amount of petrole- 
um products consumed in the United States promotes greater 
energy self-sufficiency, which helps achieve an important national 
security objective. 

2. Since manufacturers use only a small proportion of the motor 
fuels consumed in the United States, a tax on motor fuels would 
have relatively little effect on U.S. competitiveness in international i 
trade. 

3. Increasing the motor fuels taxes on as many types of transpor- 
tation as possible would avoid competitive disadvantages among in- 
dustry segments. 

4. Motor fuels are taxed at substantially higher rates outside the 
United States. In 1982 (fourth quarter) the energy tax on gasoline 
in the 10 major International Energy Agency countries was 91.3 
cents per gallon versus an average Federal-State tax of 15 cents per 
gallon in the United States (the Federal excise tax on highway 
motor fuels was increased from 4 cents to 9 cents per gallon in 
1983, and the tax on diesel fuel was increased from 9 cents to 15 
cents per gallon in 1984.) ^ 

Arguments against the proposals 

1. Excise taxes imposed at a flat rate are regressive, i.e., they 
cost the poor a larger percentage of available income than the 
taxes cost wealthier individuals making the same purchases. In 
1985, gasoline expenditures were 17.04 percent of income for per- 
sons with income of less than $5,000 and only 2.28 percent of 
income for persons with income of more than $50,000.^ 

2. The taxes on motor fuels have been imposed exclusively as 
earmarked transportation user taxes for over thirty years. Use of 
these taxes for general deficit reduction would be viewed by some 
as an inappropriate violation of this policy. 

3. Increased taxes on diesel fuel may encourage evasion of the 
tax through use of untaxed home heating oil, which is essentially 
equivalent to diesel fuel, as a motor fuel. 

4. The burden of the highway motor fuels taxes is greater in the 
sparsely populated States where distances traveled per capita is 
greater than the national average. 



* International Energy Review, Energy Information Administration, August 1985. 
^ The Distributional Aspects of an Increase in Selected Federal Excise Taxes, Congressional 
Budget Office Staff Working Paper, January 1987. 



65 
Revenue Effect 

[Fiscal years, billions of dollars] 



Proposal 1 1988 1989 1990 1988-90 

Increase present Highway Trust Fund 
motor fuels tax rates by — 

5 cents per gallon 4,7 4.5 4.5 13.7 

10 cents per gallon 9.3 9.0 8.8 27.1 

Index present highway use motor fuels 
tax rates to CPI after 10-cent in- 
crease in rate 9.3 9.7 10.3 29.4 

Increase present highway use motor 
fuels tax rates (other than diesel fuel 
tax) by — 

5 cents per gallon 4.0 3.8 3.8 11.6 

10 cents per gallon 7.9 7.5 7.4 22.8 

Increase present highway use motor 
fuels tax rates and extend tax to 
LUST tax base with increases of — 

5 cents per gallon 5.0 4.9 4.8 14.7 

10 cents per gallon 10.0 9.6 9.4 28.9 

^ All proposals except indexing would be effective on October 1, 1987, with 
appropriate floor stocks taxes being imposed. Indexing would be effective on 
January 1, 1989. 



b. Collection of gasoline and diesel fuel excise taxes 

Present Law 

Gasoline excise tax ' 

The excise tax on gasoline is imposed on the sale of the product . 
by the producer, defined to include a registered wholesale dealer. 
Beginning on January 1, 1988, tax will be imposed on removal of s 
the gasoline (or a gasoline blend stock) from the refinery, or upon 
its removal from customs custody. An exception is included under , 
the new rules permitting bulk transfers to bonded terminals with- : 
out payment of tax. In such cases, terminal operators are liable for 
payment of the tax upon removal of the gasoline from the termi- 
nal. 

Diesel fuel and special motor fuels excise taxes 

The diesel fuel and special motor fuels excise taxes generally are 
imposed on the sale of the taxable fuel by a retail dealer to the ul- 
timate consumer of the fuel. Under an exception, retail dealers 
may elect to have wholesale distributors collect and pay the tax 
when the diesel fuel is sold to the retailer. 

Possible Proposals 

Gasoline excise tax 

The gasoline tax could be collected in all cases on removal of the 
gasoline (including any gasoline blend stock) from the refinery, or 
upon removal from the first storage point in U.S. customs custody. 

Diesel fuel and special motor fuels excise taxes 

The election to collect the diesel fuel excise tax on sales by 
wholesale dealers could be made mandatory for all sales. The spe- 
cial motor fuels excise tax could likewise be imposed on sale of the 
fuel by a wholesale distributor. 

Pros and Cons 
Arguments for the proposals 

1. Deferring imposition of the motor fuels excise taxes until sale 
at or near retail has, in the past, encouraged tax-avoidance 
schemes. Imposing these taxes at an earlier stage in their market- 
ing would reduce opportunities for evading payment of the fuels 
taxes. 

2. Collection of excise taxes at the point in the distribution chain 
with the fewest number of taxpayers provides for more efficient ad- 
ministration of the tax since there are fewer taxpayers for the In- 
ternal Revenue Service to monitor. 

(66) 



67 

3. Collecting these excise taxes at a uniform point eliminates any 
special advantage for a single industry segment (e.g., integrated op- 
erations versus independent wholesale distributors). 

Arguments against the proposals 

1. Much blending of gasoline is accomplished after gasoline blend 
stocks leave the refinery. Collecting the tax exclusively upon re- 
moval from the refinery would produce administrative complexity 
when additional tax (with credits for tax previously paid) was im- 
posed on products blended after the initial point of taxation in a 
manner that increased the quantity of the product. 

2. Advancing the point of collection for excise taxes forces small 
businesses to inventory these costs when they purchase the taxable 
commodity. The increased cost resulting from buying gasoline tax- 
paid could impose financial hardship on some small wholesale deal- 
ers. 

Revenue Effect 

[Fiscal years, billions of dollars] 
Proposal 1 1988 1989 1990 1988-90 

Collect gasoline tax at refinery gate 0.3 (2) (2) 0.3 

Collect diesel fuel and special motor 
fuels taxes on sale to retail dealer 0.1 0.1 0.1 0.4 

* Both proposals would be effective on October 1, 1987, with appropriate floor 
stocks taxes being imposed. 
2 Gain of less than $50 million. 



c. Income tax credit and excise tax exemption for certain 
alcohol fuels 

Present Law 
Alcohol fuels credit 

A 60-cents-per-gallon income tax credit is allowed for alcohol 
used in certain mixtures of alcohol with gasoline (i.e., gasohol), 
diesel fuel, or any special motor fuel, if the mixture is (i) sold by j 
the producer for use as a fuel or (ii) used as a fuel by the producer, i 
The credit also is permitted for alcohol (other than alcohol used in j 
a mixture with other taxable fuels), if the alcohol is used by the 
taxpayer as a fuel in a trade or business or is sold at retail by the ! 
taxpayer and placed in the fuel tank of the purchaser's vehicle. \ 

The amount of any person's allowable alcohol fuels tax credit is 
reduced to take into account any benefit received with respect to 1 
the alcohol under the excise tax exemptions for alcohol fuels mix- i 
tures or alcohol fuels (described below). 

Excise tax exemptions for alcohol fuels mixtures and alcohol fuels ' 

Alcohol fuels mixtures ' 

Present law provides a 6-cents-per-gallon exemption from the', 
excise taxes on gasoline, diesel fuel, and special motor fuels fori; 
mixtures of any of those fuels with at least 10-percent alcohol, i 
(This is equivalent to 60 cents per gallon of alcohol in a 10-percent \ 
mixture.) 

"Neat" alcohol fuels 

A 6-cents-per-gallon exemption from the excise tax on special 
motor fuels is provided for certain "neat" methanol and ethanol 
fuels derived from a source other than petroleum or natural gas. A 
4y2-cents-per-gallon exemption is provided for these fuels when de- 
rived from natural gas. "Neat" alcohol fuels are fuels comprised of 
at least 85 percent methanol, ethanol, or other alcohol. 

Possible Proposals 

The credit and excise tax exemptions for alcohol fuels could be 
repealed. (The President's 1987 and 1988 budget proposed repeal of 
the excise tax exemptions only.) 

Pros and Cons 

Arguments for the proposal 

1. The alcohol fuels tax incentives are inefficient because they 
provide as excessive subsidy to alcohol fuels. For example, the 60- 
cents-per-gallon credit (or the equivalent excise tax exemption) pro- 

(68) 



69 

vides a Federal subsidy equal to $25.20 per barrel of oil equivalent, 
an amount higher than the cost of gasoline. 

2. The gasoline and other motor fuel excise taxes and the alcohol 
fuels credit were enacted as user taxes to finance, on a pay-as-you- 
go basis, construction of the interstate highway system; the excise 
tax exemption is contrary to this objective in exempting certain 
highway users from tax. 

3. A subsidy no longer is needed for a gestation period for a new 
industry, since the successful ethanol-producing technologies are 
well known now and subsequent changes are more likely to be in- 
cremental refinements than major technological changes. 

Arguments against the proposal 

1. Tax incentives are necessary to encourage development and 
maintenance of viable alternatives to petroleum fuels. This is par- 
ticularly true, given the high level of U.S. dependence on imported 
oil and the associated national security consequences. 

2. Since the interstate highway system is virtually complete, the 
case for protecting highway user tax revenues is weakened. 

3. Production of ethanol for use as a motor blending agent helps 
to use up some surplus agricultural products. 

Revenue Effect 

[Fiscal years, billions of dollars] 



Proposal 1 1988 1989 1990 1988-90 



Repeal alcohol fuels excise tax exemp- 
tions and alcohol fuels credit 0.2 0.2 0.2 0.7 



1 The proposal would be effective on October 1, 1987, with appropriate floor stock 
taxes being imposed. 



9. Gas Guzzler Excise Tax 

Present Law 

Under present law, an excise tax is imposed on automobiles that 
do not meet statutorily specified fuel economy standards. The 
amount of the tax varies according to the fuel efficiency of a par- 
ticular model of automobile. For 1986 and later model year automo- 
biles, no gas guzzler tax is imposed if the fuel economy of the auto- 
mobile model is at least 22.5 miles per gallon (as determined by the 
Environmental Protection Agency). For automobiles not meeting 
that standard, the tax imposed begins at $500 per automobile and 
increases to $3,850 for automobile models with fuel economy of less 
than 12.5 miles per gallon. Some limousines, pickup treks, vans, 
and the output of small manufacturers are exempt from the tax. 
The gas guzzler tax is imposed on the manufacturer or importer. 

Possible Proposals 

1. The rates of the gas guzzler tax could be doubled. 

2. The fuel economy standards could be tightened by increasing 
those standards by one mile per gallon for each of the model years 
1990 through 1994. 

3. The exemptions from the tax could be eliminated. 

4. The Customs Service, rather than the IRS, could collect the 
tax on all imported vehicles. 

5. The tax could be indexed for inflation. 

Pros and Cons 
Arguments for the proposals 

1. Increasing the tax would improve the fuel economy of vehicles 
sold in the United States, which would be beneficial from an 
energy policy standpoint. Although the levels of the tax increased 
each year from 1980 through 1986, no further increases are sched- 
uled after 1986. 

2. The gas guzzler tax can be considered a voluntary tax, because 
consumers can choose to purchase automobiles not subject to the 
tax instead of choosing automobiles subject to the tax. 

3. Some imported vehicles on which the tax should be imposed 
because of the level of their fuel efficiency may escape the tax, be- 
cause they are imported privately or through the grey market. 
(Collection by the Customs Service of the tax on imported cars 
would reduce this problem.) 

Arguments against the proposals 

1. Increasing the fuel economy standards without substantial 
lead time could present difficulties for manufacturers, who general- 

(70) 



71 

ly require significant lead time to improve the fuel efficiency of 
automobiles. 

2. The tax is not directly related to energy conservation, because 
the tax is not proportional to the amount of fuel consumed. 

Revenue Effect 

[Fiscal years, billions of dollars] 
Proposal 1 1988 1989 1990 1988-90 

a. Double present tax 0.1 0.1 0.1 0.2 

b. Increase mileage limits (2) (2) 

1 All proposals except indexing would be effective on October 1, 1987; indexing 
would be effective on January 1, 1988. 

2 Gain of less than $50 million. 



10. Increase Trust Fund Excise Taxes to Offset Implicit General 
Fund Contributions to Such Funds 

Present Law 

Revenues equivalent to gross receipts from several present-law 
Federal excise taxes are dedicated to trust funds and may be used 
only for specified purposes. For example, revenues equivalent to 
gross receipts raised by the gasoline tax are dedicated to the High- 
way Trust Fund for use in highway-related programs. 

The net revenue derived by the Federal Government from impo- 
sition of such taxes and tariffs is less than the gross receipts from 
such taxes or tariffs. This occurs because excise tax revenues dis- 
place other consumer expenditures and thus reduce taxable in- 
comes in other sectors by an equal amount; income taxes are there- 
by reduced. Because amounts equivalent to gross receipts, rather 
than net revenues to the Treasury, are transferred to trust funds 
under present law, all trust funds receive an implicit appropriation 
from general revenues. 

In many instances, other Federal tax expenditures provide an ad- 
ditional trust fund contribution from general revenues. For exam- 
ple, the revenue loss from tax-exempt bonds issued by State or 
local governments to finance activities for which they are reim- 
bursed with Federal trust fund monies (e.g., highway and airport 
construction), or for which the users generally are the same as 
those who pay particular trust fund taxes, is not deducted from 
amounts transferred from general revenues to established trust 
funds. 

The following table lists the current Federal trust (or special) 
funds and selected excise taxes, revenues from which are dedicated 
to the funds: 

(72) 



T3 



Fund 



Dedicated Taxes 



Highway Trust Fund 



Airport and Airway Trust 
Tax 



Hazardous Substance Su- 
perfund 

Oil Spill Liability Trust 
Fund 

Leaking Underground 

Storage Storage Tank 
Trust Fund 

Harbor Maintenance Trust 
Fund 

Inland Waterways Trust 
Fund 

Aquatic Resources Trust 
Fund 

Black Lung Disability 
Trust Fund 

Deep Seabed Trust Fund 



Pittman-Robertson Fund 



Gasoline, diesel fuel, and special 
motor fuels taxes 

Heavy truck retail excise tax 

Use tax on heavy trucks 

Tax on tires for heavy highway vehi- 
cles 

Air passenger ticket tax 
International departure tax 
Domestic air cargo tax 
General aviation fuels taxes 

Tax on feedstock chemicals 

Crude oil tax 

Tax on certain imported substances 

Crude oil tax ^ 

Gasoline and motor fuels taxes 



Port use tax 

Tax on fuels used by commercial 
cargo vessels 

Tax on fuels used in motorboats 
Sport fishing equipment tax 

Coal excise tax 

Tax on mining of certain hard miner- 
als from the seabed 

Bows and arrows taxes 
Manufacturers tax on certain fire- 
arms and ammunition 



^ This tax will be effective only if qualified authorizing legislation is enacted by 
September 1, 1987. 



Possible Proposals 

1. All Federal excise taxes that are dedicated to trust (or special) 
funds could be increased by 33 percent to offset the implicit contri- 
bution to those funds from general revenues from the reduction in 
income tax receipts arising from imposition of excise taxes, with 
the additional revenues being retained in general revenues rather 
than being transferred to the trust funds. 

2. In addition to possible proposal 1, specific trust (or special) 
fund taxes could be increased by an additional amount equivalent 
to the revenue loss from outstanding tax-exempt bonds to finance 
trust fund and related activities. As provided in possible proposal 1, 



74 

the additional revenues could be retained in general revenues 
rather than being transferred to the trust funds. 

Pros and Cons 
Arguments for the proposal 

1. Spending programs the funding of which is derived from spe- 
cial, dedicated taxes should not be underwritten with general reve- 
nues, absent an explicit determination by Congress to appropriate 
such amounts. Some trust-fund-related programs currently are 
funded by such explicit appropriations from general revenues. Con- 
tinuation of the implicit general revenue transfers that occur 
under the current trust fund procedure where transfers are based 
on gross receipts rather than net revenues is an evasion of the ap- 
propriations process. 

2. Basing transfers to trust funds on net revenues, rather than 
on gross receipts as is presently done, would ensure a more accu- 
rate link between revenue source and program beneficiary in those 
cases where Congress has determined that funding for specified 
programs should be limited to that derived from program benefici- 
aries. 

3. The explosive growth of tax-exempt bond issuance, with its ac- 
companying Federal revenue loss, has been a source of concern to 
Congress in recent years. Reducing trust fund transfers to reflect 
the revenue loss from such bonds used to finance trust fund 
projects would appropriately transfer the cost of the bonds from 
taxpayers generally to users of trust fund facilities without directly 
limiting or otherwise affecting the use of tax-exempt bonds to fi- 
nance such facilities. 

Arguments against the proposals 

1. In addition to the specific beneficiaries of trust fund programs 
(i.e., persons who pay the dedicated taxes), there is a general public 
benefit derived from most such programs. The implicit transfer 
from general revenues under present trust fund practices recog- 
nizes this benefit and appropriately assigns its cost to the popula- 
tion at large. 

2. Sales to the Federal Government and to State and local gov- 
ernments are exempt from certain of the trust fund excise taxes. 
These governments, representing the population at large, benefit 
from the trust fund programs under present law. The implicit gen- 
eral revenue contributions like those presently occurring are one 
method of assigning the cost of the benefits received by these gov- 
ernmental units to ultimate beneficiaries. 



75 
Revenue Effect 



Proposal 1 1988 1989 1990 1988-90 

a. Increase trust fund excise tax rates 

by 33 percent 4.4 4.7 4.9 14.0 

b. Increase trust fund excise tax rates 
by additional amount over 33 per- 
cent to offset revenue loss from out- 
standing tax-exempt bonds 9.2 9.8 10.1 29.0 

1 Both proposals would, be effective on October 1, 1987, with appropriate floor 
stocks taxes being imposed. 



11. Federal Unemployment Tax Act (FUTA) Provisions 

a. Index FUTA wage base 

Present Law 

The minimum net FUTA tax imposed on employers is 0.8 per- 
cent of the first $7,000 of wages paid to each employee during the 
year. The gross FtFTA tax rate is 6.2 percent, but employers in 
States meeting certain Federal requirements and having no delin- 
quent Federal loans are eligible for a 5.4-percent credit, making the 
minimum net FUTA tax rate 0.8 percent. 

Possible Proposal 

The $7,000 limit on wages subject to the FUTA tax could be in- 
dexed to reflect the annual increase in average wages. In order to 
allow States time to make the required conforming changes, the 
proposal would be effective for years after 1988. 

Pros and Cons 
Argument for the proposal 

Indexing the FUTA wage base generally would maintain the 
FUTA tax revenues as a constant percentage of total wages. 

Argument against the proposal 

Additional FUTA revenues should be generated only in response 
to specific needs relating to unemployment compensation, rather 
than in response to a general concern for revenue. 

Revenue Effect 

[Fiscal years, billions of dollars] 
Proposal 1988 1989 1990 1988-90 

Index FUTA wage base (effective Janu- 
ary 1, 1989) 0.2 0.6 0.8 

(76) 



b. Extension of portion of FUTA due to expire after 1987 
Present Law 

Under present law, the gross FUTA tax rate of 6.2 percent of the 
first $7,000 in wages paid to an employee consists of a permanent 
component of 6.0 percent and a temporary component of 0.2 per- 
cent. (The net FUTA tax is 0.8 percent after taking into account 
the 5.4 percent credit for State unemployment taxes.) The funds 
generated by the temporary portion of the tax have been used to 
repay advances made from general revenues to the Extended Un- 
employment Compensation account. These advances have been uti- 
lized to pay for the Federal Supplemental Benefit program and the 
Federal share of the permanent extended benefit program. 

The temporary 0.2-percent tax component is scheduled to expire 
at the beginning of the first year following the year in which the 
advances from general revenues are repaid. The advances were 
fully repaid in 1987. As a result, for the year beginning January 1, 
1988, the FUTA tax rate will be 6.0 percent (0.6 percent after 
taking into account the 5.4 percent credit for State unemployment 
tEixes). 

Possible Proposal 

The temporary FUTA tax component of 0.2 percent could be ex- 
tended three years through 1990. 

Pros and Cons 
Argument for the proposal 

In light of the current budget situation, it is inappropriate to 
allow a reduction in a tax to which employers have become accus- 
tomed. 

Arguments against the proposal 

1. The temporary FUTA tax component of 0.2 percent was in- 
tended to serve a specific purpose, i.e., to repay certain advances. 
Since that purpose has been served, the tax should be allowed to 
expire. 

2. The reduction in the FUTA tax will encourage the employ- 
ment of low-income workers and will offset the increase in employ- 
er social security taxes scheduled for 1988. 

(77) 



78 
Revenue Effect 

[Fiscal years, billions of dollars] 



Proposal 1988 1989 1990 1988-90 

Extended FUTA repayment tax for 3 
years 0.7 1.0 1.0 2.7 



B. General Consumption Taxes 
Present Law 

Present law does not include any form of broad-based consump- 
tion tax. Manufacturers' and retailers' excise taxes are imposed on 
the sale of selected products. These taxes are not sufficiently uni- 
form or coordinated to be considered as a general consumption tax 
system. 

A value added tax bill was introduced by the Chairman of the 
Ways and Means Committee in the 96th Congress (and hearings 
held), but was not reported out of Committee. The 1984 Treasury 
Department Report to the President on "Tax Reform for Fairness, 
Simplicity, and Economic Growth," examined the VAT concept, but 
did not recommend inclusion of such a tax in the Administration's 
tax reform proposals. 

Possible Proposals 

1. Value added tax ("VAT") 

A value added tax is a multi-stage sales tax on the value added 
to goods and services by each business in the production and distri- 
bution chain. Since the retail price of a product is equal to the 
total of the values added at each stage of production and distribu- 
tion, a value added tax is the economic equivalent of a retail sales 
tax. 

Tax liability may be calculated in a number of ways. All of the 
member countries in the European Economic Community use the 
"invoice" or "credit" method. Under this method, a firm calculates 
the tax on its sales, and is allowed to claim a credit for the tax im- 
posed on its purchases. Any excess of tax imposed on purchases 
over the tax due on sales is either refunded or carried forward as a 
credit against future tax liability. Imports are subject to the VAT, 
and the VAT on exports is credited or rebated. 

Under a consumption-type VAT, a credit for tax on capital equip- 
ment purchases eliminates the burden of the tax on capital goods. 
Since only consumption goods bear the tax, the incidence of the tax 
is on consumers. The consumption-type VAT is used throughout 
Europe. There are, in addition to the consumption VAT, two other 
types of VAT. The gross product type does not allow any credit for 
the tax paid on capital items. Under the income type VAT, the tax 
paid on a capital item is credited over the life of the asset. 

2. Business alternative minimum tax ("BAMT") 

As an alternative to the invoice method, a multi-stage sales tax 
could be imposed using the subtractive method. Under the subtrac- 
tive method, a firm computes its tax liability by subtracting its 
purchases from other firms from its sales, and by applying the tax 

(79) 



80 

rate to the difference. The BAMT uses the subtractive method: a 
tax would be imposed on net business receipts, which are defined 
as the excess of any business receipts over business expenses 
during the taxable period. The tax also would be imposed on im- 
ports. Business receipts attributable to exports would be exempt 
from tax. 

Credits could be allowed for (1) the employer's share of FICA and 
Railroad Retirement tax liabilities, and one-half of self-employment 
tax liability, (2) income tax liability (reduced by income tax cred- 
its), and (3) the tax equivalent of net operating losses. 

Revenues from the BAMT could be used to provide a capital 
gains exclusion, reinstate a 5-percent investment credit, repeal the 
alternative minimum tax, lower income tax rates, as well as to 
reduce the Federal budget deficit. 

Pros and Cons 
Arguments for the proposals 

1. Under the General Agreement on Tariffs and Trade ("GATT"), 
sales taxes may be imposed on a destination basis (place of con- 
sumption) rather than an origin basis (place of production). Thus, 
unlike an income tax, a sales tax may be imposed on imports and 
rebated on exports. 

2. A number of studies of alternative tax systems have concluded 
that a broad-base consumption tax would result in greater long-run 
capital formation and GNP than an equal revenue broad-base 
income tax. 

3. The subtractive method used to compute the BAMT may be 
less burdensome to taxpayers than the invoice method. 

4. Under the BAMT, the credit for a portion of the payroll taxes 
mitigates the regressive impact to some extent. Specific exclusions 
for certain necessities (e.g., food, housing and medical costs) or in- 
creases in transfer payments could lessen the regressivity. 

Arguments against the proposals 

1. The 1984 Treasury Report on tax reform concluded that imple- 
mentation of a Federal value-added tax would take 18 months from 
the date of enactment and, when fully in force, would require an 
additional 20,000 personnel, and would cost about $700 million to 
enforce. 

2. A VAT is a sales tax which largely would be borne by consum- 
ers. The burden of such a tax likely would be regressive. 

3. The BAMT does not operate as a conventional minimum tax 
since tax liability is unrelated to profitability: for example, taxpay- 
ers with losses could have substantial BAMT liability. Also, the al- 
lowance of a credit for origin-based taxes (i.e., payroll and income 
taxes) against the BAMT may be a technical violation of the 
GATT. 

4. Many empirical studies of savings behavior have failed to find 
a significant relationship between individual savings rates and 
marginal income tax rates. Thus, substitution of consumption for 
income taxes may not have a large effect on national savings. 



81 
Revenue Effect 

[Fiscal years, billions of dollars] 



Proposal 1988 ^ 1989 1990 1988-90 

5-percent VAT 69.5 100.7 103.4 

5-percent VAT with exceptions for 

food, housing, and medical care 40.2 58.3 59.8 

7-percent BAMT 2 27.8 41.2 43.9 112.9 

^ Assumes effective date of January 1, 1988. 

2 Estimate does not include revenue reduction attributable to possible BAMT 
credits (for FICA, income tax liability, and NOLs) or to possible other revenue 
offsets, such as a capital gains exclusion, 5-percent investment credit, or repeal of the 
alternative minimum tax. 



C. Securities Transfer Excise Tax 
Present Law 

Under present law, no tax is imposed upon the transfer of corpo- 
rate stock or any other security, other than income taxes attributa- 
ble to any gain realized by the transferor. Transfer taxes were im-' 
posed, however, on transfers of certain securities from 1918 to 1965. f 
Immediately prior to repeal in 1965, the transfer tax was imposed, 
at a rate of 0.1 percent of value on the original issue and 0.04 per-^ 
cent on subsequent transfers of stock, and was imposed at a rate of ^ 
0.05 percent on the original issue and 0.05 percent on the subse- 
quent trading of certificates of indebtedness. 

Possible Proposals ] 

1. A securities transfer excise tax ("STET") could be imposed at a 
rate of 0.5 percent of value upon transfers of certain securities. The 
securities subject to the tax could include stock and debt securities, \ 
whether or not publicly traded, options, futures, forward contracts,, 
and other items, such as limited partnership interests, that are 
close substitutes to the above securities. 

The transfers subject to the STET could include sales or ex- 
changes, gifts, transfers at death, transfers pursuant to divorce, 
transfers to a trust, transfers pursuant to mergers or acquisitions, 
and transfers upon issuance or redemption of a security. Special 
rules would apply to transactions with certain elements and to^ 
pass-through entities. 

2. The rate of tax in possible proposal 1 could be 1.0 percent of 
value. 

Pros and Cons 
Arguments for the proposal 

1. If revenues are to be raised by increasing Federal excise taxes, ] 
a STET should be preferred to other options because the likely 
high concentration of securities ownership among higher income 
taxpayers would make a STET more progressive than many other 
Federal excise taxes. 

2. Because the STET would not be paid directly by the popula- 
tion at large (unlike, e.g., the income tax), there may be less opposi- 
tion to the STET than to an increase in certain other taxes. 

3. A reduction in securities trading, especially short-term trad- 
ing, that is likely to occur as a result of the imposition of a STET, 
would be beneficial because large amounts of stock in the hands of 
investors with short-term investment objectives place undue pres- 
sure on corporate managers to achieve short-term results at the ex- 
pense of more effective long-term strategies. 

(82) 



83 

4. Imposition of a STET would discourage speculative, short-term, 
high-risk trading by managers of pension funds; these risks are in- 
appropriate for the management of funds intended for retirement 
use. 

5. Imposition of a STET would reduce merger and acquisition ac- 
tivity which has resulted in insider trading abuses as well as the 
diversion of managerial efforts. 

Arguments against the proposal 

1. The progressivity of a STET would be limited because a signifi- 
cant amount of wealth is held by pension funds on behalf of lower- 
and middle-income individuals. 

2. Imposition of a STET would increase the cost of capital to 
firms if pre-tax yields on securities issued after the effective date 
are increased to compensate for the additional tax burden. 

3. The reduction in short-term trading that may be attributable 
to a STET may be undesirable because active short-term trading 
provides valuable signals to management regarding shareholder 
perceptions of corporate strategies, and also increases liquidity and 
decreases volatility of security prices. 

4. A STET imposed in the United States could encourage some 
participants in U.S. capital markets to transfer their securities to 
foreign exchanges which had no such tax or a tax with a lower 
rate. 

Revenue Effect 

The revenue effect of a STET would be heavily dependent on pre- 
cisely how the tax is structured. In the absence of a specific propos- 
al and in order to provide some indication of the order of magni- 
tude of the revenue effect, the following is presented for a reasona- 
ble broad based securities transfer tax of 0.5 percent. 



[Fiscal years, billions of dollars] 
Proposal 1988 1989 1990 

0.5 percent 5.0 7.5 10.0 



D. Income Tax Provisions 
1. Individual and Corporate Tax Rates and Surtaxes 

Present Law 
Individuals 

In the Tax Reform Act of 1986, tax structures for each of the 
four filing classifications, which had 14 or 15 marginal tax rates ^ 
and taxable income brackets, were replaced by a five-step marginal 
rate structure for 1987 and by two marginal rates and a phaseouti 
rate for 1988 and later years. The zero bracket amounts of prior 
law have been replaced by the standard deduction, which is deduct- 
ed from adjusted gross income in the process of determining tax- 
able income. 

In 1987, the marginal tax rates are 11 percent, 15 percent, 28 
percent, 35 percent, and 38.5 percent. The maximum tax rate on 
long-term capital gain in 1987 is 28 percent. 

There are two marginal tax rate brackets — 15 percent and 28 
percent — for each filing classification for 1988 and later years. In 
addition, some taxpayers in effect will be subject to a 33-percent 
tax rate on taxable income above specified amounts; this phaseout 
tax rate will apply as income rises until the tax benefits of the 15- 
percent bracket and the personal exemption amount deductions 
have been phased out. The 33-percent phaseout rate reverts to 28, 
percent for income levels above that at which the phaseout has 
been completed. Beginning in 1988, long-term capital gain will be 
taxed as ordinary income; a transitional maximum capital gains 
rate of 28 percent applies in 1987. 

Corporations 

Through June 30, 1987, the corporate income tax rate structure 
has a top rate of 46 percent, which applies to taxable income in 
excess of $100,000. Lower marginal tax rates apply to taxable 
income less than $100,000, but the tax benefit of the lower rates is 
phased out (beginning at taxable income above $1 million). The 
lower marginal rate structure is 15 percent on taxable income to 
$25,000; 18 percent between $25,000 and $50,000; 30 percent be- 
tween $50,000 and $75,000; and 40 percent between $75,000 and 
$100,000. 

Under the Tax Reform Act of 1986, a new corporate tax rate 
structure will become effective on July 1, 1987. This structure has 
a top corporate tax rate of 34 percent, which applies to taxable 
income in excess of $75,000. Below $75,000, a 15-percent rate ap- 
plies to taxable income to $50,000, and 25 percent to $75,000. A 
phaseout of the 15- and 25-percent tax rates begins at taxable 
income above $100,000. 

(84) 



85 

For taxable years that include parts of both tax rate structure 
periods, taxpayers will apply the two tax rate structures in propor- 
tion to the number of days in the taxable year that includes each 
of the tax structures. For example, in the case of a calendar year 
corporate taxpayer with $2 million of ordinary taxable income, the 
tax for 1987 is computed by first determining a tentative tax under 
prior law of $920,000 (46 percent of $2 million) and a tentative tax 
under the amended law of $680,000 (34 percent of $2 million). The 
actual tax equals the sum of $456,219.18 (181/365 of $920,000) and 
$342,794.52 (184/365 of $680,000) or $799,013.70, for a total tax rate 
of approximately 40 percent. 

Corporate net capital gain properly taken into account after De- 
cember 31, 1986, is taxed at a 34-percent rate. 

Possible Proposals 

1. Provide a five-percent surtax on individual and corporate 
income tax liabilities, including individual and corporate minimum 
tax liabilities. 

2. Provide a five-percent surtax on individual and corporate 
income tax liabilities, including individual and corporate minimum 
tax liabilities, above $10,000. 

3. Extend the 1987 tax rate schedules for both individuals and 
corporations for one year through 1988, for a longer period (with 
indexing), or indefinitely (with indexing). 

4. Create an third marginal tax rate of 33 percent for individuals 
that would apply to taxable income at and above the level at which 
the phaseout of the tax benefits of the 15-percent rate bracket and 
personal exemptions applies. 

5. The same as (4) above, except add a 38.5-percent tax bracket 
that begins at taxable income above $225,000 (on a joint return) 
and retain the maximum capital gains tax rate at 28 percent. 

Pros and Cons 
Arguments for the proposals 

1. Taking into account the provisions of the 1986 Act that broad- 
ened the income tax base and provided fairer treatment of all tax- 
payers, the relative income tax burden of each taxpayer would not 
be disturbed if the income tax liabilities of all taxpayers are in- 
creased by the same proportion. 

2. Compared to many excise tax options, an income tax surcharge 
would not discriminate among products or geographic regions. 

3. A surtax would involve little additional compliance or collec- 
tion costs because withholding and estimated payments simply 
would be increased by the amount of the surtax. 

4. A precedent for an income tax surtax was established in the 
Revenue and Expenditure Control Act of 1968 (enacted on June 28, 
1968) in which a 10-percent surtax was imposed on individual tax 
liabilities (effective as of April 1, 1968) and on corporate tax liabil- 
ities (effective as of January 1, 1968). The surtax expired on June 
30, 1970. 

5. If a surtax or an increase in marginal tax rates were enacted, 
a surtax on minimum tax liability or a proportionate increase in 



86 

minimum tax rates would be necessary to maintain all taxpayers I 
in the same relative position. ' 

6. Proposals (4) and (5) would eliminate the phaseout and provide 
permanent 33- and 38.5-percent tax rate brackets, thereby eliminat- 
ing the inequity under present law of allowing the highest income 
taxpayers to pay a 28-percent tax rate on taxable income above the 
phaseout range where the 33-percent phaseout rate applies. For ex- 
ample, on a joint return, a taxpayer could be paying 28 percent on 
taxable income above $200,000 while another taxpayer with i 
$145,000 taxable income would be paying a 33-percent phaseout 
rate. 

In addition, there is a widespread perception that the tax rate 
cut for high income individuals was excessive, and that the top 
marginal tax rate should be different for, e.g., married taxpayers 
with taxable incomes of $70,000, $150,000, and $500,000. 

7. The amount of a taxpayer's income is the best measure of abil- 
ity to pay taxes. An income tax surtax or increase in marginal tax 
rates would not be regressive relative to income, as increases in 
excise taxes tend to be. 

Arguments against the proposals 

1. Any increase in tax rates, whether in the form of a temporary 
surtax or an increase in all or selected tax rates, would be an in- 
crease in rates that would break a pledge made to taxpayers on en- 
actment of the base-broadening and other provisions of the Tax 
Reform Act of 1986 that eliminated or reduced deductions, credits, 
etc. 

2. Any need to increase budget receipts through the income tax 
would be met best by enacting additional base-broadening provi- 
sions, which also would increase the equity of the tax structure 
even further. As a result, greater compliance is more likely to be 
achieved because low- and middle-income taxpayers would believe 
that the income tax system would be even more fair to all income 
groups. 

3. Increased income tax rates would have adverse effects on eco- 
nomic efficiency — reduced savings, reduced work effort, and other 
distortions. 

4. Increasing tax rates of higher income individuals would be 
unfair because many of them incurred the greatest increase in in- 
dividual tax burdens under the base-broadening provisions of the 
1986 Act. 

5. Selective increases in other taxes, primarily various excise 
taxes, would make it possible to tax consumer spending that would 
not be discouraged by higher taxes, and to adjust excise tax rates 
to levels that would be perceived as more appropriate than present 
rates. 

6. Individual income and social insurance tax payments make up 
more than three-fourths of budget receipts. Using other tax sources 
to raise revenues for budget reduction would provide greater bal- 
ance and diversification of revenue sources. 

7. With respect to temporary surtax proposals, many individuals 
and corporations would not believe that the increase would not be 
extended indefinitely. 



87 
Revenue Effect 

[Fiscal years, billions of dollars] 



Proposal 1988 1989 1990 1988-90 

Individual and corporate tax rates and 
surtaxes: 

a. 5-percent individual surtax 10.3 20.1 22.6 53.0 

b. 5-percent corporate surtax 3.6 6.3 7.0 16.9 

c. 5-percent individual surtax on tax 

over $10,000 3.1 6.2 7.4 16.7 

d. 5-percent corporate surtax on tax 

over $10,000 3.3 5.9 6.4 15.7 

e. Freeze 1987 rate schedule: 

(1) One year (individual) 9.0 7.4 16.4 

(2) One year (corporate) 8.2 5.5 13.7 

(3) Permanent freeze with index- 
ing (individual) 9.0 18.8 23.0 50.9 

f. Impose 33-percent rate on income 
levels above phaseout of personal 

exemptions 2.8 6.5 8.8 18.2 

g. 38.5-percent top rate above 
$225,000 of income (for joint re- 
turns), with 33-percent intermedi- 
ate rate; 28-percent gains rate 4.7 9.9 12.3 26.9 



74-267 0-87-4 



2. Reduction in Individual and Corporate Tax Preferences 

Present Law 

A number of provisions in the income tax law and regulations! 
provide economic incentives to the private sector or tax relief to 
particular kinds of taxpayers. These tax provisions, often referred] 
to as preferences, generally take the form of exclusions, credits, de-1 
ductions, and deferrals of tax liability. 

Preferences make possible the reduction of tax liability in rela- 
tion to economic income. In some cases, the amount of tax reduc-i 
tion that can be accomplished through the use of preferences is) 
limited by the alternative minimum tax. However, the minimum 
tax does not apply to all items that could be considered prefer-' 
ences, and applies to some preferences only in part. Moreover, even 
preferences that are fully subject to the minimum tax can be used 
by taxpayers to reduce tax liability, because the minimum tax rate 
is lower than the regular tax rate. 

Under present law, corporate tax preferences relating to percent- 
age depletion for coal and iron ore, excess bad debt reserves of 
banks, interest to acquire certain previously acquired tax-exempt 
bonds, FSC income, amortization of pollution control facilities, 
mining development and exploration expenditures, and intangible 
drilling costs of integrated oil companies are subject to an across- 
the-board cutback ranging from 20 to 30 percent. 

Possible Proposals 

1. The value of tax preferences could be directly reduced by a 
specified percentage. Such reductions in the value of preferences 
would apply to all taxpayers for regular tax purposes and, for pref- 
erences currently allowed in computing minimum tax, for mini- 
mum tax purposes. 

This approach involves reducing by a percentage the gross 
amount of items such as exclusions, deductions that permit the per- 
manent understatement of income (rather than the deferral of tax 
liability), and credits. With respect to items that permit the defer- 
ral of tax liability, the approach would involve permitting such de- 
ferral only with respect to a percentage of the item involved. For 
example, if applied to accelerated depreciation, the approach would 
involve requiring a portion of basis to be deducted more slowly, 
rather than permanent disallowance of a portion of depreciation 
deductions. 

Preferences that could be reduced include the credits for child 
and dependent care expenses, clinical testing expenses, and produc- 
ing fuel from nonconventional sources; the investment tax credit; 
the targeted jobs tax credit; the alcohol fuels tax credit; the re- 
search credit; and the possessions tax credit. The reduction could 

(88) 



89 

apply to itemized deductions for individuals, deductions for ACRS, 
pollution control facility amortization, circulation expenditures, re- 
search and experimental expenditures, expenses for tertiary injec- 
tants, excess percentage depletion, intangible drilling costs, mining 
exploration and development expenses, business entertainment de- 
ductions, foreign convention attendance expenses, certain travel ex- 
penses, financial institution preferences, soil and water conserva- 
tion expenditures, and the small life insurance company deduction. 

The benefits of incentive stock options, foreign sales corporations, 
deferral for foreign controlled corporations, tax exemption for 
credit unions, certain ESOP loans, lump-sum averaging, sales to 
ESOPs, and shipping income deferral also could be reduced. Also, 
the dollar limitations for the one-time housing gain exclusion, the 
foreign earned income exclusion, the expensing of depreciable prop- 
erty, amortization of reforestation expenditures, IRA deductions, 
employee gifts, luxury cars, and pension plan benefits and contri- 
butions could be reduced. The tax-exempt bond ceilings could be 
lowered. In addition, the alternative minimum tax rate also could 
be increased. 

2. The present law corporate cutbacks in section 291 could be in- 
creased by a set percentage. 

Pros and Cons 
Arguments for the proposals 

1. In periods of large budget deficits, across-the-board reductions 
in tax preferences are appropriate. 

2. The taxpayers affected by the proposals generally would be 
those paying relatively less tax in relation to economic income. 

3. The proposals could be designed to have a relatively uniform 
effect on preferences, and thus not to have a disproportionate effect 
on particular taxpayers or tax preference items. 

Arguments against the proposals 

1. The proposals could reduce the value of preferences that it was 
considered desirable to retain in full. 

2. The proposals could increase the complexity of the income tax 
system, by requiring additional mathematical computations. 

3. The tax preferences that would be reduced were enacted or re- 
tained in the Internal Revenue Code of 1986 to accomplish some 
social or economic purpose. These goals could be undermined by a 
reduction in the preferences. 



90 
Revenue Effect 

[Fiscal years, billions of dollars] 



Proposal 1988 1989 1990 1988-90 

Across-the-board reduction in indi- 
vidual tax preferences (10 percent 
for itemized deductions; 20 per- 
cent for certain credits and pref- 
erences) 1.2 11.4 11.8 24.4 



3. Individual Income Tax Provisions 

a. Credit for child and dependent care expenses 
Present Law 

Present law provides a tax credit equal to up to 30 percent of cer- 
tain employment-related child and dependent care expenses. For 
example, expenses of a day care center or home infant care are eli- 
gible for the credit if incurred to enable the taxpayer to work. The 
amount of such expenses eligible for the credit is limited to $2,400 
($4,800 for the care of two or more individuals). 

The 30-percent credit rate is reduced by one percentage point for 
each $2,000 (or portion thereof) of adjusted gross income (AGI) be- 
tween $10,000 and $28,000. The credit rate is 20 percent for individ- 
uals with AGI exceeding $28,000. 

Possible Proposals 

1. The credit rate could be reduced by one percentage point for 
each $2,000 (or portion thereof) by which AGI exceeds $50,000. Under 
this proposal, no credit would be allowed to taxpayers with AGI 
exceeding $88,000. 

2. Expenses of overnight camps could be made ineligible for the 
credit. 

Pros and Cons 
Arguments for the proposals 

1. Under present law, the child care credit may be claimed by 
high-income individuals who do not need Federal tax subsidies for 
their child care expenses. 

2. In many cases, high-income individuals claim a credit for ex- 
penses that would be incurred regardless of whether both spouses 
are working outside the home, e.g., nursery school, housekeeper, 
and summer camp costs. 

3. In the case of a parent's expenditures to send a child to an 
overnight camp (such as a summer camp in a vacation area), the 
personal element of the expenditure predominates over any 
income-producing connection. Accordingly, tax subsidies should not 
be given for the costs of sending a child away from home to camp 
merely because the child's parent or parents work outside the 
home. 

Arguments against the proposals 

1. To the extent that child care expenses incurred to enable the 
taxpayer to work represent expenses of earning income, the tax 
treatment of such expenses should be the same for all eligible tax- 
payers regardless of income level. 

(91) 



92 

2. Middle-income two-earner couples lost various deductions as a 
result of the 1986 Act, such as the two-earner deduction and IRAs. 
To disallow the child care credit in addition would be perceived as 
unfair. 

3. There is no reason to allow the credit for costs of a child's at- 
tending a day camp while not in school but to deny it merely be- 
cause the child attends an overnight camp, since both types of ex- 
penditures enable the child's parent or parents to work outside the 
home. 

Revenue Effect 

[Fiscal years, billions of dollars] 
Proposal 1988 1989 1990 1988-90 

Phaseout credit for AGI over 
$50,000 0.3 0.4 0.7 

Deny credit for overnight camp ex- 
penditures (1) 0.1 0.1 0.1 

1 Gain of less than $50 million. 



b. Interest expense deduction on home equity loans 
Present Law 

Under present law, as amended by the 1986 Act, the itemized de- 
duction for personal interest is being phased out over the period 
1987-1990. Personal interest is any interest, other than interest in- 
curred or continued in connection with the conduct of a trade or 
business (other than the trade or business of performing services as 
an employee), investment interest, or interest taken into account in 
computing the taxpayer's income or loss from passive activities for 
the year. These rules are phased-in and become fully effective in 
1991. 

Present law provides that qualified residence interest is not sub- 
ject to the limitation on personal interest. Qualified residence in- 
terest is interest on debt secured by a security interest valid 
against a subsequent purchaser on the taxpayer's principal resi- 
dence or a second residence of the taxpayer. Interest on such debt 
is generally deductible to the extent that the debt does not exceed 
the amount of the taxpayer's basis for the residence (including the 
cost of home improvements). Present law also allows a taxpayer to 
deduct as qualified residence interest the interest on certain loans 
incurred for educational or medical expenses up to the fair market 
value of the residence. A grandfather rule treats interest on debt 
incurred on or before August 16, 1986 and secured by the taxpay- 
er's principal or second residence as qualified residence interest, 
provided the amount of the debt does not exceed the fair market 
value of the residence. 

Thus, under present law, a taxpayer may deduct interest on a 
loan secured by a lien on his or her residence, up to the amount of 
the original cost of the residence (plus improvements), even though 
the loan proceeds are used for personal purposes. These loans are 
being advertised by lending institutions as "home equity loans". 

In computing an individual's alternative minimum tax under 
present law, personal interest is deductible only if that interest is 
on a loan which was incurred in acquiring, constructing, or sub- 
stantially rehabilitating a taxpayer's residence. Thus, interest on 
"home equity loans" not used for such purposes is not deductible in 
computing the minimum tax. 

Possible Proposals 

1. The rule currently applicable under the minimum tax limiting 
the deduction for interest on a qualified residence loan to interest 
incurred in connection with a loan to acquire, construct, or reha- 
bilitate a taxpayer's principal or second residence could be adopted 
for purposes of the regular tax. 

(93) 



94 

2. The interest deduction for home equity loans for noneduca- 
tional, nonmedical purposes could be limited to $10,000 per year. 

3. Interest on home equity loans without a fixed term could be 
made nondeductible. 

4. The amount of debt eligible for the qualified residence excep- 
tion could be limited to $1 million. 

5. It could be clarified that boats and mobile homes are ineligible 
to qualify as second residences for purposes of the interest expense 
deduction. 

Pros and Cons 
Arguments for the proposals 

1. The proposals would tend to limit the interest deductions to 
situations where the incentive would directly encourage home own- 
ership. 

2. Present law discriminates against persons who have no equity 
in their homes against which to borrow when personal indebted- 
ness is incurred. These proposals would treat all taxpayers more 
nearly equally with respect to these personal loans. 

3. The proposals would carry out the intention of Congress to 
prevent deduction of interest on debt used to acquire consumer 
goods which do not give rise to taxable income. 

4. Present law encourages persons to give lenders a lien on their 
residence for consumer debt, which could cause loss of the resi- 
dence in the case of nonpayment of the loan. These proposals 
would take away that encouragement. 

Arguments against the proposals 

1. The proposals might encourage homeowners to make low down 
payments and arrange loans with small or no principal payments 
in order to maximize interest deductions. There is no sound public 
policy reason for encouraging taxpayers to do so. 

2. The proposals would encourage individuals to borrow more 
than they really need to purchase a house in anticipation of future 
needs for funds. 

3. The proposals could make borrowing for educational and medi- 
cal purposes more costly. 

4. The proposals may be contrary to the policy of allowing some 
level of deductibility of personal interest in the case of homeown- 
ers. 



95 
Revenue Effect 

[Fiscal years, billions of dollars] 



P^"PQS^' 1988 1989 1990 1988-90 

Interest expense deduction on 
home equity loans: 
Limit to acquisition indebted- 
ness 02 17 IS 98 

$10,000 limit (other than edu- 

cation and medical) (i) 0.3 0.3 6 

$1 million cap (i) o.3 0.3 6 

coats and mobile homes in- 
eligible as second residences (1) (1) (1) 



(^) 



^ Gain of less than $50 million. 



c. other itemized deductions 

(1) Disallowance of deduction for nonbusiness personal property 
taxes 

Present Law 

Under present law, itemizers may deduct three types of State 
and local taxes whether or not incurred in a trade or business or in 
an investment activity — individual income taxes, real property 
taxes, and personal property taxes. (State and local sales taxes 
were made nondeductible under the Tax Reform Act of 1986, begin- 
ning in 1987.) 

In general, personal property taxes on nonbusiness property are 
deductible only if imposed (1) on an annual basis, and (2) substan- 
tially in proportion to the value of the personal property that is 
subject to tax. (For example, itemized deductions are allowed for 
personal property taxes imposed, in some States, on automobiles, 
motorcycles, and boats used for personal purposes.) A tax on per- 
sonal property that is based in part on criteria other than the 
value of the property, or that is collected either more or less fre- 
quently than once per year, may qualify for deductibility, as may a 
tax imposed in the form of a privilege. For example, vehicle regis- 
tration fees based partly on value and partly on other criteria 
(such as weight) may be deductible in part. 

At present, some 26 States (or their subdivisions) impose taxes on 
one or more types of tangible personal property not used for busi- 
ness or investment purposes, such as boats or automobiles used for 
personal purposes. 

Possible Proposal 

The itemized deduction for personal property taxes that are not 
incurred in a trade or business or in an investment activity could 
be repealed. (The May 1985 tax reform proposals of President 
Reagan called for disallowing itemized deductions for all nonbusi- 
ness taxes, including nonbusiness personal property taxes.) 

Pros and Cons 
Arguments for the proposal 

1. Personal property taxes that are not incurred in a trade or 
business or in an investment activity — for example, such taxes im- 
posed on personal vehicles or boats — are expenditures of a personal 
or consumption nature. Personal expenditures generally are not de- 
ductible in light of tax policies that deductions should be allowed 
only for expenditures essential to earning income, and that person- 
al consumption should not be subsidized through the tax system. 

(96) 



97 

2. Deductions for State and local personal property taxes benefit 
only those taxpayers with a narrow range of consumption patterns 
(in contrast to State and local income taxes) and do not benefit 
home ownership (in contrast to State and local real property taxes). 
Less than one-third of returns filed by itemizers for 1983 claimed 
deductions for nonbusiness personal property taxes. 

Arguments against the proposal 

1. The deduction disallowance could adversely affect the ability 
of State and local governments to utilize personal property taxes in 
meeting their revenue needs. 

2. The deduction disallowance would result in more favorable 
treatment to itemizers living in States that impose only real prop- 
erty or income taxes than to taxpayers in States that rely in part 
on personal property taxes to meet their revenue needs. 

Revenue Effect 

[Fiscal years, billions of dollars] 
Proposal 1988 1989 1990 1988-90 

Disallow deduction for nonbusiness 
personal property tax 0.1 0.4 0.4 0.9 



(2) Imposition of floor under aggregate itemized deductions for^ 
higher-income taxpayers 

Present Law i 

Individuals may elect to itemize their allowable deductions for 
certain personal expenditures if the total of itemizable deductions 
exceeds the applicable standard deduction amount. Under present 
law, there is no other overall limitation imposed on the allowance 
of itemized deductions. 

However, present law imposes floors under certain of the item- 1 
ized deductions. Medical expenses may be deducted only to the 
extent exceeding 7.5 percent of the taxpayer's adjusted gross 
income (AGI). Casualty and theft losses greater in amount than 
$100 each may be deducted only to the extent that the sum of all 
such losses (net of related gains) exceeds 10 percent of AGI. Miscel- 
laneous itemized deductions generally are allowed only to the 
extent the total amount exceeds two percent of AGI. 

Possible Proposal 

A floor equal to 10 percent of the taxpayer's adjusted gross 
income in excess of $100,000 ($50,000 for a single individual) could 
be placed under the total amount of the taxpayer's itemized deduc- 
tions. For example, if married individuals with AGI of $210,000 had 
total itemizable deductions (allowable after taking into account the 
present-law specific floors) of $28,000, their allowable itemized de- 
ductions would be reduced to $17,000. 

Pros and Cons 
Arguments for the proposal 

1. Most itemized deductions represent expenses incurred for per- 
sonal consumption or financial purposes, and are not related to 
costs of earning income in a trade or business. Accordingly, limit- 
ing the aggregate amount of itemized deductions is consistent with 
the general tax policy that deductions should be allowed only for 
expenditures essential to earn income, and that personal consump- 
tion should not be subsidized through the tax system. 

2. The proposed floor under aggregate itemized deductions also 
would be consistent with the policy (reflected in the specific floors 
under certain itemized deductions) that deductions for personal ex- 
penditures should be limited to involuntary and unusually large 
expenditures that may exhaust a large proportion of the taxpayer's 
total income for a particular year, thereby significantly affecting 
his or her ability to pay taxes. Since the proposal would impose a 
floor under, but not a ceiling on, itemized deductions, the taxpayer 
still could deduct amounts of expenses or losses that could be cata- 
strophic relative to the taxpayer's income and ability to pay taxes. 

(98) 



99 

3. By reducing the number of taxpayers who itemize, rather than 
using the standard deduction, the proposed floor would contribute 
to tax simplification and reduce recordkeeping, verification, and 
audit burdens on taxpayers and the IRS. The allowance of itemized 
deductions has long been recognized as a primary cause of complex- 
ity for individual taxpayers, particularly since intricate rules and 
limitations apply in determining eligibility for, and in computing, 
most itemized deductions. 

Arguments against the proposal 

1. The largest itemized deductions for most taxpayers are home 
mortgage interest and State and local income and real property 
taxes. Limitations placed on these deductions would contravene 
long-standing tax policies with respect to home ownership and 
comity with State and local governments. 

2. There is no rationale for imposing an overall floor in addition 
to the specific floors that already place significant limitations on 
the deductibility of medical expenses, casualty and theft losses, and 
certain miscellaneous itemized deductions. 

3. If an overall floor reflects appropriate tax policy, the floor 
should apply to all itemizers, including those with AGI below 
$100,000/$50,000. Further, a more equitable and straightforward 
way to impose a higher effective tax rate on individuals with AGI 
above a specified level would be through adjustments to the rate 
structure. 

Revenue Effect 

[Fiscal years, billions of dollars] 
Proposal 1988 1989 1990 1988-90 

Floor under aggregate itemized de- 
ductions of 10 percent of AGI 
over $50,000 ($100,000 for joint 
returns) 1.0 7.2 8.7 16.9 



(3) Limitation on tax-liability reduction for top-bracket individuals 

Present Law 

Under present law, the allowance of itemized deductions provides 
a greater tax benefit for such expenditures of a personal or con- 
sumption nature to higher-bracket taxpayers than to lower-bracket 
taxpayers. For example, itemized deductions of $10,000 in 1988 will 
reduce the tax liability of an individual in the 15-percent bracket 
by $1,500, but will reduce the tax liability of an individual in the 
28-percent bracket by $2,800. 

Possible Proposal 

The deduction for itemized deductions could be allowed only 
against the lowest (15 percent) tax rate. Alternatively, the deduc- 
tion could be converted into a 15-percent tax credit. 

Pros and Cons 
Argument for the proposal 

All taxpayers would receive the same tax benefit from the same 
dollar amount of itemized deductions. This would eliminate the 
greater proportionate benefits that higher-income taxpayers re- 
ceive under present law, so that charitable contributions (for exam- 
ple) would receive the same tax subsidy regardless of the income 
level of the donor. 

Arguments against the proposal 

1. The proposal would conflict with the rationales and objectives 
for allowing itemized deductions, such as the encouragement of 
home ownership and charitable giving and the proper measure- 
ment of the ability to pay taxes, and would affect adversely the 
ability of State and local governments to raise needed tax reve- 
nues. 

2. The proposal would add further complexity to tax computa- 
tions for itemizers; also, taxpayers would have difficulty under- 
standing the reason for changing the basic structure of the item- 
ized deductions. 

Revenue Effect 

[Fiscal years, billions of dollars] 



Proposal 


1988 


1989 


1990 


1988-90 


Limit itemized deductions to 15 
percent tax bracket 


3.4 


22.7 


24.7 


50.7 







(100) 



4. Business Meal and Entertainment Expenses 

Present Law 

Meal and entertainment expenses incurred for business or in- 
vestment reasons are deductible if certain legal and substantiation 
requirements are met. The amount of the deduction generally is 
limited to 80 percent of the expense that meets these requirements. 

Possible Proposal 

The percentage of otherwise allowable meal and entertainment 
expenses that is deductible could be reduced, for example, from 80 
percent to 75 percent or 50 percent. 

Pros and Cons 
Arguments for the proposal 

1. Meal and entertainment expenses have a personal consump- 
tion element even when they serve a legitimate business purpose 
and are not excessive. This personal consumption element justifies 
disallowing more than 20 percent of the deduction. 

2. Deductions for meal and entertainment expenses involve many 
abuses, such as excessive expenditures and deductions for expendi- 
tures that were not truly business-motivated. In view of the diffi- 
culty, from an administrative and enforcement standpoint, of pre- 
venting these abuses, overall deductions should be restricted fur- 
ther. 

Arguments against the proposal 

1. In many circumstances, meal and entertainment deductions 
represent legitimate business expenses that should not be limited 
further. 

2. Taxpayers who claim legitimate deductions should not be pe- 
nalized because of abuses by other taxpayers. 

Revenue Effect 

[Fiscal years, billions of dollars] 



Proposal 




1988 


1989 


1990 


1988-90 


a. Allow 75% deductibility 




0.2 

1.3 


0.5 

2.4 


0.6 

2.8 


1.3 


b. Allow 50% deductibility 




6.6 










(101) 











5. Employee Benefits; Pensions; ESOPs 

a. Employee benefits 
(1) Limit the exclusion of employer-provided health coverage 

Present Law 

In general, employer-provided health coverage is excludable from 
an employee's income. The exclusion is conditioned, however, on 
the coverage being provided under a plan meeting certain nondis- 
crimination and qualification requirements. 

Employer-provided health coverage is unconditionally excludable 
from wages for purposes of the FICA and FUTA taxes. 

Possible Proposals 

1. In the Treasury Department Report to the President issued in 
November of 1984, Treasury proposed that employer contributions 
to a health plan be included in an employee's income to the extent 
that they exceed $70 per month ($840 per year) for individual cov- 
erage of an employee, or $175 per month ($2,100 per year) for 
family coverage (i.e., coverage that includes, in addition to the em- 
ployee, the spouse or a dependent of the employee). The dollar 
limits were to be adjusted annually to reflect changes in the Con- 
sumer Price Index. 

These limits, which could be set at higher amounts, would apply 
for FICA and FUTA purposes as well as income tax purposes. 

2. The President's tax reform proposal of May 1985 proposed re- 
quiring employer contributions to a health plan to be included in 
an employee's income up to $10 per month for individual coverage 
or $25 per month for family coverage. 

3. The cap on excludable health benefits could be applied only for 
FICA and FUTA purposes. 

4. The exclusion of employer-provided health coverage from 
wages for FICA and FUTA purposes could be repealed. 

Pros and Cons 
Arguments for the proposals 

1. The exclusion from income and wages of employer-provided 
health coverage can result in taxpayers with the same economic 
income paying different amounts of tax because of the form in 
which their compensation is received. The exclusion from income 
and wages also narrows the tax base, either causing higher tax 
rates or reducing needed revenues. 

2. The exclusion from income favors taxpayers in a higher tax 
bracket over taxpayers in a lower tax bracket, because the higher 
the bracket, the more valuable the exclusion. Moreover, the rules 

(102) 



103 

establishing the exclusion are structured to permit larger exclu- 
sions for highly compensated employees, increasing the bias in 
favor of high-bracket taxpayers. 

3. The exclusion from income and wages has encouraged unnec- 
essarily generous health coverage that leads to overutilization of 
health services and higher costs for such services. 

4. The policy objective of encouraging the provision of health cov- 
erage to low- and middle-income employees justifies the exclusion 
from income and wages only up to a point. A cap on the exclusion 
for health benefits is justified because, when the employer-provided 
coverage is too expensive, the costs and inequities described above 
of excluding the excessive portion of the benefit outweigh the mar- 
ginal benefit of encouraging the provision of the corresponding 
amount of supplementary health coverage. 

5. Inclusion of all or excess employer-provided health coverage in 
wages for FICA purposes would allow low- and middle-income em- 
ployees to earn credit toward social security benefits by virtue of 
compensation received in the form of health coverage. As a result, 
lower income employees would not be forced (in the case of a con- 
tributory health plan that is voluntary) to choose between current 
health insurance coverage and future social security benefits. 

Arguments against the proposals 

1. The full exclusion from income and wages of employer-provid- 
ed health coverage, to the extent conditioned on effective nondis- 
crimination rules prohibiting the plan from favoring highly com- 
pensated employees, is justified, as a matter of social policy, by the 
fact that such exclusion encourages the provision of needed health 
coverage to low- and middle-income employees who otherwise 
might not purchase such coverage. 

2. If any of the proposals were enacted, employers would be less 
likely to provide adequate health coverage to low- and middle- 
income employees. In addition, many of such employees would not 
purchase adequate health coverage on their own. Accordingly, such 
employees may in some cases need public assistance. The cost of 
providing this assistance may well exceed the cost of retaining the 
present-law exclusion of employer-provided health coverage from 
income and wages. 

3. If a limitation is based on a flat dollar amount of employer 
contributions (rather than, for example, on a value concept based 
solely on the health coverage features), it would discriminate 
against employers (and their employees) that have higher per em- 
ployee costs for the same health coverage. Examples of such em- 
ployers are (1) small employers, (2) employers in high cost regions, 
and (3) employers with older workforces. 

4. The determinations of whether the limits on health coverage 
have been exceeded will be administratively burdensome for em- 
ployers and the IRS. 



104 
Revenue Effect 

[Fiscal years, billions of dollars] 



Proposal 1988 1989 1990 1988-90 

(l)Cap exclusion ($840/$2,100 

per year) - ^-^ ^-^ ^'^ ^^'^ 

(2) Floor on exclusion ($120/$300 

per year 2.8 4.2 4.6 11.6 

(3) Cap exclusion for FICA and 
FUTA only $840/$2,100 per 
year) 1.2 2.1 2.6 

(4) Repeal exclusion for FICA 
and FUTA only 9.1 14.6 16.7 



(2) Repeal the exclusion of employer-provided group-term life insur- 
ance 

Present Law 

In general, employer-provided group-term life insurance is ex- 
cludable from an employee's income. The exclusion is conditioned, 
however, on the insurance being provided under a plan meeting 
certain nondiscrimination and qualification requirements. In addi- 
tion, the exclusion does not apply to coverage in excess of $50,000. 

Employer-provided group-term life insurance is unconditionally 
excludable from wages for purpose of the FICA and FUTA taxes. 

Possible Proposals 

1. In the Treasury Department Report to the President issued in 
November of 1984, Treasury proposed that the exclusion from 
income of employer-provided group-term life insurance be repealed. 
The repeal also could apply to the exclusion of employer-provided 
group-term life insurance from wages for FICA and FUTA pur- 
poses. 

2. The exclusion from wages for FICA and FUTA purposes of em- 
ployer-provided group-term life insurance could be repealed. 

Pros and Cons 
Arguments for the proposals 

1. The exclusion of employer-provided group-term life insurance 
from income and wages can result in taxpayers with the same eco- 
nomic income paying different amounts of tax because of the form 
in which their compensation is received. In addition, the exclusion 
from income and wages also narrows the tax base, thereby requir- 
ing higher tax rates to produce a given amount of revenues. 

2. The exclusion from income favors taxpayers in a higher tax 
bracket over taxpayers in a lower tax bracket, because the higher 
the bracket, the more valuable the exclusion. Moreover, the rules 
establishing the exclusion are structured to permit larger exclu- 
sions for highly compensated employees, increasing the bias in 
favor of high-bracket taxpayers. 

3. The costs and inequities of the exclusion, described above, out- 
weigh the marginal beneficial effect of the exclusion. 

4. The proposal would allow low- and middle-income employees 
to earn credit toward social security benefits by virtue of compen- 
sation received in the form of group-term life insurance. 

5. Because death benefits (as well as the value of up to $50,000 
coverage) from group-term life insurance are tax free while bene- 
fits in excess of $5,000 from self-insured arrangements are taxable, 
present law favors the provision of death benefits through life in- 

(105) 



106 

surance companies over self-insured arrangements through the 
income exclusion for group-term life insurance. 

Arguments against the proposal 

1. The exclusion from income and wages of employer-provided 
group-term life insurance, to the extent conditioned on effective 
nondiscrimination rules prohibiting the favoring of highly compen- 
sated employees, is justified, as a matter of social policy, by the fact 
that such exclusion encourages the provision of the insurance to 
low- and middle-income employees who otherwise might not pur- 
chase such insurance. 

2. If any of the proposals were enacted, employers would be less 
likely to provide group-term life insurance to low- and middle- 
income employees. In addition, many of such employees would not 
purchase life insurance on their own. Accordingly, their survivors 
may in some cases need public assistance, because social security 
survivor benefits often are inadequate. The cost of providing this 
assistance may well exceed the cost of retaining the present-law ex- 
clusion of employer-provided group-term life insurance from 
income and wages. 

3. The limit on the exclusion of employer-provided group-term 
life insurance from income is sufficiently low to ensure that it 
cannot be used to provide unnecessarily generous protection. 

Revenue Effect 

[Fiscal years, billions of dollars] 
Proposal 1988 1989 1990 1988-90 

(1) Repeal exclusion 2.0 3.1 3.2 8.4 

(2) Repeal exclusion for FICA 

and FUTA only 0.8 1.3 1.3 3.4 



(3) Repeal the $5,000 exclusion for employer-provided death benefits 

Present Law 

Death benefits paid by an employer to the estate or beneficiaries 
of a deceased employee generally are excluded from the recipient's 
income. The maximum amount, however, that may be excluded 
from income with respect to any employee is $5,000. 

Possible Proposal 

In the Treasury Department Report to the President issued in 
November of 1984, and the President's tax reform proposal of May 
1985, it was proposed that the $5,000 exclusion from income of em- 
ployer-provided death benefits be repealed. 

Pros and Cons 
Arguments for the proposal 

1. The exclusion of employer-provided death benefits from 
income can result in taxpayers with the same economic income 
paying different amounts of tax because of the form in which their 
income is received. In addition, the exclusion from income also nar- 
rows the tax base, thereby requiring higher tax rates to produce a 
given amount of revenue. 

2. The exclusion from income favors taxpayers in a higher tax 
bracket over taxpayers in a lower tax bracket, because the higher 
the bracket, the more valuable the exclusion. Moreover, the rules 
establishing the exclusion would permit the employer to provide 
the benefit only for highly compensated employees, exacerbating 
the problem that high-bracket taxpayers are favored. 

3. The costs and inequities of the exclusion, described above, out- 
weigh the marginal beneficial effect of the exclusion. 

Arguments against the proposal 

1. The exclusion from income of employer-provided death bene- 
fits is justified, as a social policy, by the fact that such exclusion 
encourages the provision of the death benefits with respect to low- 
and middle-income employees who otherwise might not purchase 
life insurance. 

2. If the proposal were enacted, employers would be less likely to 
provide death benefits to low- and middle-income employees. In ad- 
dition, many of these lower income employees would not purchase 
life insurance on their own. Accordingly, their survivors may in 
some cases need public assistance, because social security survivor 
benefits often are inadequate. The cost of providing this assistance 
may well exceed the cost of retaining the present-law exclusion of 
employer-provided death benefits from income. 

(107) 



108 

3. The limit on the exclusion of employer-provided death benefits 
from income is sufficiently low to ensure that it cannot be used to 
provide unnecessarily generous benefits. 

Revenue Effect 

[Fiscal years, billions of dollars] 
Proposal 1988 1989 1990 1988-90 

Employer-provided death benefits (^) (^) (^) 0.1 

^ Gain of less than $50 million. 



\ 



(4) Repeal the exclusion of employer-provided dependent care assist- 
ance 

Present Law 

In general, employer-provided dependent care assistance is ex- 
cludable from an employee's income. The exclusion is conditioned, 
however, on the assistance being provided under a plan meeting 
certain nondiscrimination and qualification requirements. In addi- 
tion, the exclusion is limited to $5,000 in a taxable year ($2,500 in 
the case of a separate return by a married individual). 

Employer-provided dependent care assistance is excludable from 
wages for FICA and FUTA purposes if, at the time the assistance is 
provided, it is reasonable to assume the assistance will be excluda- 
ble from income. 

Dependent care expenses (defined in the same manner as with 
respect to the exclusion) paid for by an individual are eligible for a 
nonrefundable credit against income tax liability of up to 30 per- 
cent (phasing down to 20 percent for higher income taxpayers). For 
this purpose, dependent care expenses are limited to $2,400, if 
there is one dependent, and $4,800, if there are two or more de- 
pendents. 

Possible Proposals 

1. In the Treasury Department Report to the President issued in 
November of 1984, Treasury proposed that the exclusion from 
income of employer-provided dependent care assistance be re- 
pealed. The repeal also could apply to the exclusion of employer- 
provided dependent care assistance from wages for FICA and 
FUTA purposes. 

Employer-provided dependent care assistance would be eligible 
for the dependent care credit. 

2. The exclusion from wages for FICA and FUTA purposes of em- 
ployer-provided dependent care assistance could be repealed. 

Pros and Cons 
Arguments for the proposals 

1. The exclusion of employer-provided dependent care assistance 
from income and wages can result in taxpayers with the same eco- 
nomic income paying different amounts of tax because of the form 
in which their compensation is received. The exclusion from 
income and wages also narrows the tax base, thereby requiring 
higher tax rates to produce a given amount of revenue. 

2. The exclusion from income favors taxpayers in a higher tax 
bracket over taxpayers in a lower tax bracket, because the higher 
the bracket, the more valuable the exclusion. This is contrary to 
the policy explicit in the structure of the dependent care credit. 

(109) 



110 

Moreover, the rules establishing the exclusion are structured to 
permit larger exclusions for highly compensated employees, in- 
creasing the bias in favor of high-bracket taxpayers. 

3. Because the dependent care credit (to the extent available) is 
more advantageous for low-income employees, the exclusion largely 
functions to enable high-income taxpayers to obtain a larger tax 
benefit than they would otherwise obtain under the dependent care 
credit. 

4. The costs and inequities of the exclusion, described above, gen- 
erally outweigh the marginal beneficial effect of the exclusion. 

5. It is inequitable to permit employees receiving employer-pro- 
vided benefits to be exempt from FICA while individuals who pay 
for dependent care themselves are required to pay FICA on the 
wages used to purchase this care. The proposals would allow low- 
and middle-income employees to earn credit toward social security 
benefits by virtue of compensation received in the form of depend- 
ent care assistance. 

Arguments against the proposal 

1. The exclusion from income and wages of employer-provided de- 
pendent care assistance, to the extent conditioned on effective non- 
discrimination rules prohibiting the favoring of highly compensat- 
ed employees, is justified, as a matter of social policy, by the fact 
that the exclusion encourages the provision of the assistance to 
low- and middle-income employees who otherwise might not pur- 
chase the dependent care or, at least, not the same quality of de- 
pendent care. 

2. If a taxpayer's dependent care expenses exceed the amount eli- 
gible for the credit, the exclusion will be advantageous regardless 
of income level. In addition, there are a significant number of 
middle-income taxpayers for whom the exclusion is more beneficial 
than the credit. Thus, retaining the exclusion is justified as a 
matter of social policy. 

3. The social policies served by encouraging the provision of de- 
pendent care by employers include: (1) enabling many individuals 
to return to work who otherwise could not afford to; (2) increasing 
worker productivity to the extent that the worker need not be con- 
cerned during the workday with dependent care; and (3) increasing 
the quality of care provided to children of working parents. 

4. Valuing dependent care assistance for inclusion purposes 
would impose a substantial administrative burden on employers 
and on the IRS. 

Revenue Effect 

[Fiscal years, billions of dollars] 



Proposal 


1988 


1989 


1990 


1988-90 


(1) Repeal exclusion 


(1) 
(1) 


0.1 


0.1 


0.2 


(2) Repeal exclusion for FICA and 
FUTAonly 


0.1 







' Gain of less than $50 million. 



(5) Repeal the exclusions for employee benefits with respect to high- 
income employees 

Present Law 

In general, employer-provided health coverage, group-term life 
insurance, and dependent care assistance are excludable from an 
employee's income. These exclusions are conditioned, however, on 
the benefits being provided under a plan meeting certain nondis- 
crimination and qualification requirements. In addition, the exclu- 
sion of group-term life insurance does not apply to coverage in 
excess of $50,000. The dependent care exclusion is limited to $5,000 
in a taxable year ($2,500 in the case of a separate return by a mar- 
ried individual). 

Employer-provided health coverage and group-term life insur- 
ance are unconditionally excludable from wages for purposes of the 
FICA and FUTA taxes. Employer-provided dependent care assist- 
ance is excludable from wages for FICA and FUTA purposes if, at 
the time the assistance is provided, it is reasonable to assume that 
the assistance will be excludable from income. 

Possible Proposal 

The exclusion from income and wages of employer-provided 
health coverage, group-term life insurance, and dependent care 
could be repealed for taxpayers (or employees) with adjusted gross 
mcome (or compensation) equal to or exceeding $60,000. The exclu- 
sions could be phased out between $50,000 and $60,000. In conjunc- 
tion with this proposal, the applicable nondiscrimination rules 
could be repealed with respect to such benefits. 

Pros and Cons 
Arguments for the proposal 

1. The exclusions of employee benefits from income and wages 
can result in taxpayers with the same economic income paying dif- 
ferent amounts of tax because of the form in which their compen- 
sation is received. The exclusions from income and wages also 
narrow the tax base, thereby requiring higher tax rates to produce 
a given amount of revenue. 

2. The justification for the exclusions is that they are intended to 
encourage the provision of the benefits by employers to low- and 
middle-income employees who otherwise might not purchase such 
benefits. The rationale for excluding the benefits from the income 
and wages of high-income employees is that, if the exclusions did 
not apply to high-income employees, employers would not adopt 
the employee benefit plans. In fact, for the vast majority of employ- 
ers, the provision of employee benefits, especially health coverage, 
is necessary from an employee relations perspective. Thus, denying 

(111) 



112 

the exclusions to the high-income employees generally will not 
affect employers' willingness to maintain such plans. 

3. High-income employees do not need what is, in effect, a gov- 
ernment subsidy (provided through the tax system) to purchase 
benefits. There are many examples of tax benefits that are not 
available to high-income taxpayers or are available on a more re- 
strictive basis (e.g., IRAs, dependent care credit, elderly credit, 
earned income credit). 

4. Repealing the nondiscrimination rules applicable to the speci- 
fied employee benefits would simplify the law. 

Arguments against the proposal 

1. If the exclusions are not available with respect to high-income 
employees, employers will not maintain employee benefit plans and 
thus low- and middle-income employees will not receive the bene- 
fits. 

2. In the case of a small or medium size employer, the employer's 
willingness to make benefits available generally to lower-income 
employees will be influenced to a great extent by the availability of 
an exclusion for higher-income employees. This is particularly true 
given the administrative cost to the employer of maintaining em- 
ployee benefit plans. 

3. High-income taxpayers have the same need for health cover- 
age, life insurance, and dependent care as low- and middle-income 
taxpayers. Moreover, if such benefits are not provided to them by 
their employer (due to the repeal of the exclusions), such high- 
income taxpayers may not purchase such benefits on their own. 

4. Phasing in an income inclusion as a taxpayer's income (or 
compensation) rises has the effect of increasing the taxpayer's mar- 
ginal tax rate within the phase-in range. 

Revenue Effect 

[Fiscal years, billions of dollars] 
Proposal 1988 1989 1990 1988-90 

Repeal exclusion for employee benefits 
with respect to high-income employ- 
ees 1.1 1.8 2.0 4.8 



(6) Limit the exclusion for cafeteria plan benefits 

Present Law 

Under present law, compensation generally is taxable to employ- 
ees when actually or constructively received. An amount is con- 
structively received by a taxpayer if it is made available to the tax- 
payer. 

There are various exceptions to this basic principle of construc- 
tive receipt. Under one exception, no amount is included in the 
income of a participant in a cafeteria plan meeting certain require- 
ments solely because, under the plan, a taxable benefit is available 
to the participant. Nontaxable benefits that may be available 
under a cafeteria plan include, for example, health coverage, 
group-term life insurance, and dependent care assistance. The cafe- 
teria plan exception from the principles of constructive receipt gen- 
erally also applies for purposes of FICA and FUTA taxes. 

Under another exception, an employee is not required to include 
in income employer contributions to a qualified cash or deferred ar- 
rangement merely because the employee could have elected to re- 
ceive the amount in cash. This exception to the constructive receipt 
principle is limited to $7,000 in an employee's taxable year. In ad- 
dition, this exception does not apply for FICA and FUTA purposes, 
even if the qualified cash or deferred arrangement is part of a cafe- 
teria plan. 

Possible Proposals 

1. The cafeteria plan exception to the constructive receipt princi- 
ple could be limited to a certain dollar amount, such as $500, for 
purposes of income, FICA, and FUTA taxes. As under present law, 
a plan offering an employee a choice only among nontaxable bene- 
fits would not be subject to this cap. 

2. The cafeteria plan exception to the constructive receipt princi- 
ple could be repealed for FICA and FUTA purposes. 

3. A plan offering dependent care assistance could be considered 
ineligible for the cafeteria plan exception to the constructive re- 
ceipt principle. 

Pros and Cons 
Arguments for the proposals 

1. Limiting the constructive receipt exception for cafeteria plans 
to a certain dollar amount, such as $500, would serve purposes 
similar to those served by the $7,000 limit on elective deferrals 
under a qualified cash or deferred arrangement. Because elective 
arrangements can allow some of the most needy employees to elect 
cash instead of benefits without violating the applicable nondis- 
crimination rules, the current revenue cost of cafeteria plans is not 

(113) 



114 

justified by the results. In addition, in some cases, the dollar limit 
will result in cafeteria plans functioning as supplements to none- 
lective employee benefit plans, rather than in lieu of such nonelec- 
tive plans. 

The dollar limit does not eliminate an employer's ability to allow 
different employees to choose different benefits. The dollar limit 
simply limits the tax benefits provided to such an arrangement. 

2. Repealing the cafeteria plan exception to the constructive re- 
ceipt principle for FICA and FUTA purposes would be consistent 
with the retirement plan area in which exceptions to the construc- 
tive receipt principle may reduce income, but not wages. The ra- 
tionale for such a rule is that social security is intended to be a 
mandatory program; individuals generally should not be entitled to 
elect out of the program, even partially. 

3. In general, low-income employees do not elect dependent care 
assistance under a cafeteria plan, since for them the dependent 
care credit (to the extent available) is more advantageous than the 
income exclusion for the assistance. Thus, allowing dependent care 
assistance to be elected under a cafeteria plan functions largely to 
enable high-income taxpayers to obtain a larger tax benefit for 
their housekeepers and to avoid certain restrictions applicable to 
the dependent care credit. The applicable nondiscrimination rules 
do not prevent such favoring of high-income taxpayers. 

4. A significant portion of the projected long-term deficit in the 
social security trust funds is attributable to the shrinking of the 
taxable wage base from the exclusion of fringe benefits for FICA 
purposes. As the portion of compensation paid in nontaxable fringe 
benefits grows, the size of the taxable payroll shrinks. By subject- 
ing wages excluded from income under cafeteria plans to FICA tax, 
this shrinkage in the wage base would be slowed and the long-term 
financing of social security would be strengthened. 

5. As pointed out in a study issued by the Department of Health 
and Human Services in July 1985, cafeteria plans can, under 
present law, have an adverse effect on efforts to contain health 
costs. 

Arguments against the proposals 

1. The proposed limitations on cafeteria plans would reduce their 
usage by employers and thus could result in some employees re- 
ceiving benefits they do not need and others not receiving benefits 
they do need. Such a result may lead to an inefficient use of tax 
expenditures if employers provide employees with unnecessary ben- 
efits. The concern that low- and middle-income employees will take 
cash instead of benefits is adequately addressed by the nondiscrim- 
ination rules. 

2. If one of the first two proposals were enacted, employers would 
be less likely to provide employee benefits to low- and middle- 
income employees. In addition, many of these lower-income em- 
ployees would not purchase such benefits on their own. According- 
ly, such employees may in some cases need public assistance. The 
cost of providing this assistance may well exceed the cost of retain- 
ing the present-law unlimited exclusion for cafeteria plans. 

3. If a taxpayer's dependent care expenses exceed the amount eli- 
gible for the credit, it would be advantageous for such a taxpayer 



115 



to elect dependent care expenses under a cafeteria plan regardless 
of income level. In addition, there are a significant number of 
middle-income taxpayers for whom the exclusion is more beneficial 
than the credit. Retaining the availability of dependent care assist- 
ance under a cafeteria plan thus is justified as a matter of social 



policy. 



Revenue Effect 

[Fiscal years, billions of dollars] 



Proposal 1988 1989 1990 1988-90 



(1) Cap cash option under a cafeteria 

plan ($500 per year) 0.8 1.4 1.9 4.1 

(2) Repeal cafeteria plan exception for 

FICA and FUTA only 0.6 1.2 1.7 3.5 

(3) Disqualify dependent care assist- 
ance from cafeteria plan exception (1) 0.1 0.1 0.2 

^ Gain of less than $50 million. 



(7) Exclusion from income for meals and lodging 

Present Law 

Under the Code, certain meals and lodging furnished to an em- 
ployee for the convenience of the employer are excluded from the 
employee's gross income. At the same time, the employer may still 
deduct the costs of such employee benefits (subject to the 80-per- 
cent deduction limitation with respect to business meals). 

Possible Proposals 

1. The availability of this exclusion to corporate officers and sig- 
nificant shareholders could be restricted. 

2. Employers could be denied a deduction for the direct operating 
costs of providing meals that are excludable from their employees' 
incomes on the grounds that they are furnished for the conven- 
ience of the employer. However, the employer could deduct such 
costs to the extent of reimbursements from the employees. 

Pros and Cons 
Arguments for the proposals 

1. Corporate officers and significant shareholders can have signif- 
icant influence over the corporation, which could effectively enable 
them to provide these tax benefits to themselves. 

2. There is a significant tax subsidy with respect to meals provid- 
ed for the convenience of the employer (since they are totally ex- 
cludable from the employee's income), yet there is no compelling 
policy reason for the subsidy. This subsidy could be reduced by de- 
nying the deduction for providing such meals. Denying the deduc- 
tion, rather than including the fair market value of the meals in 
income, avoids the problem that, in many cases under the particu- 
lar circumstances under which a meal is furnished for the conven- 
ience of the employer, the fair market value of the meal may be 
difficult to determine. 

Arguments against the proposals 

1. Corporate officers and significant shareholders who are em- 
ployees should be treated like other employees. 

2. Limiting the exclusion would cause administrative difficulties 
for employers and the IRS in valuing appropriately meals and lodg- 
ing furnished to an employee for the convenience of the employer. 

3. The fact that a meal is not includible in an employee's income 
should not affect the deductibility to the employer of providing the 
meal if it is a legitimate business expense provided for the conven- 
ience of the employer. 

(116) 



117 
Revenue Effect 

[Fiscal years, billions of dollars] 



Proposal 1988 1989 1990 1988-90 

(1) Restrict exclusion for corporate of- 
ficers and significant shareholders (^) (^) (^) (^) 

(2) Restrict employer 0.2 0.3 0.3 0.9 

1 Gain of less than $50 million. 



b. Pensions 
(1) Treat loans from qualified plans as distributions 

Present Law 

Under present law, an individual is permitted to borrow from a j 
qualified plan in which the individual participates (and to use his ^ 
or her accrued benefit as security for the loan) provided certain re- 
quirements are satisfied. 

In certain cases, a loan to a plan participant is treated as a tax- 
able distribution of plan benefits. This rule of income inclusion 
does not apply to the extent that the loan (when added to the out- 
standing balance of all other loans to the participant from all plans 
maintained by the employer) does not exceed the lesser of (1) 
$50,000 (reduced by the excess (if any) of (a) the highest outstand- 
ing balance of all other loans from all plans of the employer during 
the 1-year period ending on the day before the date on which the 
loan is made, over (b) the outstanding balance of such loans on the 
date the loan is made), or (2) the greater of $10,000 or one-half of 
the participant's accrued benefit under the plan. This exception ap- 
plies only if the loan is required, by its terms, to be repaid within 5 
years or, if the loan is used to acquire the principal residence of 
the participant, within a reasonable period of time. 

Possible Proposal 

Treat any loan from a qualified plan as a distribution of plan 
benefits that is includible in income to the extent the distribution 
is not treated as a return of the employee's investment in the con- 
tract under the normal basis recovery rules. 

Pros and Cons 
Arguments for the proposal 

1. The proposal would make the treatment of loans from quali- 
fied plans consistent with the treatment of loans from IRAs. 

2. The proposal would increase the likelihood that retirement 
benefits will be held until retirement by discouraging withdrawals 
through loans. 

3. Under present law, in the case of a contributory plan, employ- 
ers often provide favorable loan provisions in order to induce 
higher levels of participation by nonhighly compensated employees. 
The proposal would force employers to provide additional incen- 
tives (such as higher employer matching contributions) and, there- 
fore, should increase the total plan benefits provided to nonhighly 
compensated employees. 

(118) 



119 

Arguments against the proposal 

1. Often, an employee's retirement benefit is the employee's most 
significant source of savings. If loans from retirement plans are 
treated as taxable distributions, then an employee may not have a 
source of funds in the case of a medical or other emergency. 

2. In the case of a contributory retirement plan, the absence of a 
favorable loan provision may discourage retirement saving and, 
therefore, reduce the aggregate amount that an employee has 
available for retirement income. 

3. Unfavorable loan provisions treat an employee who partici- 
pates in a pension plan less favorably than another borrower of 
plan assets. 

Revenue Effect 

[Fiscal years, billions of dollars] 



Proposal 1988 1989 1990 1988-90 



Treat plan loans as distributions (i) 0.1 0.1 0.2 



Gain of less than $50 million. 



74-267 0-87-5 



(2) Redefine full funding limitation for pension plans 

Present Law 

Under present law, subject to annual limitations, an employer 
may make deductible contributions to a qualified defined benefit 
pension plan up to the full funding limitation. The full funding 
limitation is defined as the excess of (1) the accrued liability under 
the plan for projected benefits over (2) the plan assets. Projected 
benefits, unlike accrued benefits, are the benefits that are projected 
to be earned by normal retirement age, rather than the benefit ac- 
crued as of the close of the year. 

If a defined benefit plan is terminated, the employer's liability to 
plan participants does not exceed the plan's termination liability 
(i.e., the liability for benefits determined as of the date of the plan 
termination). A plan's termination liability may be significantly 
less than the plan's full funding limitation. 

Possible Proposal 

The full funding limitation could be defined as a multiple of a 
plan's termination liability for deduction and minimum funding 
purposes. Thus, an employer would be permitted to make a deduct- 
ible contribution to a defined benefit plan for a year to the extent 
that, after the contribution, the plan's assets do not exceed some 
percentage (e.g., 150 or 200 percent) of the plan's termination liabil- 
ity. 

Pros and Cons 
Arguments for the proposal 

1. An employer's accrued liability to employees under a defined 
benefit plan at any point in time does not exceed its liability for 
benefits in the event of plan termination (i.e., termination liabil- 
ity). An employer should not be permitted to deduct contributions 
to a defined benefit plan for liabilities that have not yet been in- 
curred by the plan if the plan assets significantly exceed this ac- 
crued liability. This rule would ensure that the deductibility of em- 
ployer contributions to pension plans is treated more consistently 
with the deductibility of payments for other accrued liabilities. 

2. Under present law, an employer may systematically overfund 
its pension plan to obtain the benefit of a current deduction and 
tax-free growth, (i.e., in order to use the pension plan as a tax-fa- 
vored savings arrangement). The present-law 10-percent excise tax 
on plan reversions does not adequately deter this systematic over- 
funding. 



(120) 



n 



121 

Arguments against the proposal 

1. The defined benefit plan funding and deduction rules were de- 
signed to encourage employers to fund for projected, rather than 
accrued, liabilities. A limitation on the employer's ability to deduct 
plan contributions may create a disincentive for funding. 

2. Employers frequently adopt funding methods that permit the 
cost of an employee's retirement benefits to be funded as a level 
annual amount over the employee's working career rather than 
funded as an employee's benefits are accrued. The proposal would 
discourage the use of these level funding methods. 

Revenue Effect 

[Fiscal years, billions of dollars] 



Proposal 


1988 


1989 


1990 


1988-90 


Modify full funding limitation (150 
percent rule) 


0.6 


1.8 


1.4 


3.9 







(3) Definition of active participant for IRA rules 

Present Law 

Under present law, a taxpayer is permitted to make deductible 
IRA contributions up to the lesser of $2,000 or 100 percent of com- 
pensation (earned income, in the case of a self-employed individual) 
if the taxpayer (1) has adjusted gross income (AGI) that does not 
exceed an applicable dollar amount or (2) is not an active partici- 
pant. In the case of a married couple filing a joint return, the AGI 
of the couple and the active participant status of either spouse is 
taken into account in determining whether a taxpayer may make 
deductible IRA contributions. 

The term "active participant" means, with respect to any plan 
year, an individual who, for any part of the plan year ending with 
or within the taxable year, is an active participant in (1) a qualified 
plan (sec. 401(a) or 403(a)), (2) a plan established for its employees 
by the United States, by a State or political subdivision thereof, or 
by an agency or instrumentality of the United States or a State or 
political subdivision, (3) a tax-sheltered annuity (sec. 403(b)), or a 
simplified employee pension (SEP) (sec. 408(k)). In addition, an indi- 
vidual is considered an active participant if the individual makes 
deductible contributions to a plan described in section 501(c)(18). 

In a recent Tax Court decision, it was held that Article III judges 
are not employees of the United States and, therefore, are not 
active participants in a plan established for its employees by the 
United States.^ Whether or not an individual is an employee is 
also relevant for other purposes under the Code, such as for the ex- 
clusion of certain benefits from income and the eligibility for cer- 
tain deductions. 

Possible Proposal 

The decision in Porter v. Commissioner could be overturned and 
officers of the United States or of a State or political subdivision as 
described in the decision could be treated as employees for pur- 
poses of the Code and as active participants for purposes of the IRA 
deduction limit. 

Pros and Cons 
Arguments for the proposal 

1. The IRA deduction rules are designed to permit individuals 
who otherwise do not participate in a qualified pension plan to 
make deductible IRA contributions in order to accumulate tax-fa- 
vored retirement income. This purpose is not served by a rule that 



' Porter v. Commissioner, 88 T.C. No. 28 (March 5, 1987). 

(122) 



123 

fails to treat as employees individuals who are earning retirement 
benefits under an employer-maintained plan. 

2. The active participant rules should treat consistently individ- 
uals who are covered under tax-favored retirement arrangements. 
Allowing certain individuals who perform services for the United 
States or for a State or political subdivision to participate in a tax- 
favored retirement plan and to make deductible IRA contributions 
does not promote this consistency of treatment. 

3. The decision in Porter v. Commissioner has implications 
beyond the specific treatment of Article III judges for purposes of 
the active participant rules. Conceivably, the decision could be in- 
terpreted to permit high-level state and Federal officials to make 
deductible IRA contributions, while other individuals who do not 
perform services for governmental entities would be denied deduc- 
tions for IRA contributions. Such a result would be perceived as in- 
equitable. Similarly, the decision could be interpreted to deny an 
exclusion from income for certain benefits (such as health benefits) 
for the individuals subject to the decision. 

Arguments against the proposal 

1. Congress intended to treat only certain plans as employer- 
maintained pension plans for purposes of the active participant 
rules. The type of plan in which an Article III judge participates is 
not the type of plan intended to be covered by the active partici- 
pant rules. 

2. The proper interpretation of the scope of the decision in Porter 
V. Commissioner is best left to the courts. 

Revenue Effect 

[Fiscal years, billions of dollars] 
Proposal 1988 1989 1990 1988-90 

Modify active participant rules (^) (^) (^) (^) 

^ Gain of less than $50 million. 



c. Repeal certain special rules relating to ESOPs 
Present Law 
Leveraged ESOPs 

Under present law, an employee stock ownership plan (ESOP) is 
a qualified stock bonus plan, or a combination of a stock bonus and 
a money purchase pension plan, designed to invest primarily in 
qualifying employer securities. 

Present law generally prohibits loans between a plan and a dis- 
qualified person. An exception to this rule is provided in the case of 
an ESOP. Thus, the employer securities held by an ESOP may be 
acquired through direct employer contributions or with the pro- 
ceeds of a loan to the trust (or trusts) from the employer or guaran- 
teed by the employer. 

An ESOP that borrows to acquire employer stock is referred to 
as a leveraged ESOP. In some cases, a leveraged ESOP borrows 
from a financial institution the funds needed to purchase the stock 
and uses the proceeds to purchase the stock. Typically, the loan is 
guaranteed by the employer. The employer stock may be pledged 
as collateral (if the loan is nonrecourse and the only assets of the 
ESOP pledged are shares purchased with the loan proceeds). 

Alternatively, the employer may borrow from a financial institu- 
tion or other lender and sell its stock to the ESOP in exchange for 
the ESOP's installment note. Under this arrangement, the ESOP 
uses employer contributions to pay off the note to the employer 
who will, in turn, use those payments to repay its lender. 

Interest exclusion for ESOP loans 

Under present law, a bank, an insurance company, a corporation 
actively engaged in the business of lending money, or a regulated 
investment company may exclude from gross income 50 percent of 
the interest received with respect to a securities acquisition loan 
used to acquire employer securities. A securities acquisition loan 
generally is defined to include (1) a loan to a corporation or to an 
ESOP to the extent that the proceeds are used to acquire employer 
securities (within the meaning of sec. 409(1)) for the plan, or (2) a 
loan to a corporation to the extent that the corporation transfers 
an equivalent amount of employer securities to the plan. 

Employer deductions for ESOP contributions 

Under present law, the contributions of an employer to a quali- 
fied plan are deductible in the year for which the contributions are 
paid, within limits (sec. 404). 

The deduction limits applicable to an employer's contribution 
depend on the type of plan to which the contribution is made and 

(124) 



125 

may depend on whether an employee covered by the plan is also 
covered by another plan of the employer. 

In the case of an ESOP described in section 4975(e)(7), special de- 
duction limits apply. Contributions to such an ESOP for a year are 
deductible to the extent they do not exceed the sum of (1) 25 per- 
cent of the compensation of the ESOP participants, in the case of 
principal payments on a loan incurred for the purpose of acquiring 
employer securities and (2) the amount of any interest repayment 
on such a loan. 

Certain dividends paid on stock held in an ESOP are deductible 
to the extent the dividends are passed through to plan participants 
or used to repay a loan with which the stock was acquired. 

Special contribution limits for ESOPs 

Under present law, overall limits apply to contributions and ben- 
efits provided to an individual under all qualified plans, tax-shel- 
tered annuities, and simplified employee plans (SEPs) maintained 
by any private or public employer or by certain related employers. 
Under a defined contribution plan (including an ESOP), present 
law provides an overall limit on annual additions with respect to 
each plan participant (sec. 415(c)). The annual additions generally 
are limited to the lesser of (1) 25 percent of an employee's compen- 
sation for the year, or (2) $30,000. 

An employer's deductible ESOP contributions that are applied by 
the plan to the payment of interest on a loan to acquire employer 
securities, as well as any forfeitures of employer securities pur- 
chased with loan proceeds generally are not taken into account 
under the rules providing overall limits on contributions and bene- 
fits under qualified plans. However, such contributions and forfeit- 
ures are disregarded for purposes of the overall limits only if no 
more than 1/3 of the employer's contributions for the year is allo- 
cated to highly compensated employees. If this 1/3 requirement is 
satisfied, the $30,000 limit on contributions may be raised up to 
$60,000. 

Possible Proposals 

1. Repeal the special rules providing an exception to the prohibit- 
ed transaction rules for ESOP loans. Repeal the special interest ex- 
clusion for a lender making a securities acquisition loan. 

2. Repeal the special deduction limits for contributions to an 
ESOP. 

3. Repeal the special limits on contributions on behalf of an em- 
ployee to an ESOP. 

Pros and Cons 
Arguments for the proposals 

1. Employers often prefer to used leveraged ESOPs as a corpo- 
rate financing technique that, because of the special tax benefits 
available to the ESOP, the employer, and certain lenders, can 
produce a lower cost of borrowing than if conventional debt or 
equity financing were used. Thus, the employer corporation may 
often use the special tax benefits designed to encourage greater 



126 

capital ownership by employees to generate general working cap- 
ital or for other purposes that do not primarily benefit employees. 
Such a use of the tax benefit is inappropriate. 

2. Leveraged ESOPs are also used as a method of protecting a 
company against a hostile takeover. A sale of stock to an ESOP 
will not necessarily dilute control of the company to the same 
degree as a sale to outside parties. The stock purchased by a lever- 
aged ESOP is not immediately credited to employees' individual ac- 
counts, but is held in a suspense account and released for alloca- 
tion to employees' accounts as the acquisition loan is repaid. 
During this period, the shares may be voted by plan trustees (who 
are frequently representatives of the management of the company) 
subject to the fiduciary rules of ERISA. It is not appropriate for the 
tax benefits accorded to ESOPs to be used by corporate managers 
who want to protect themselves against the risk of takeover. 

3. The existence of special contribution and deduction limits for 
contributions by an employer to an ESOP creates an incentive to 
maintain an ESOP as a primary source of retirement income for 
employees. The tax laws should not create an incentive for an em- 
ployer to maintain one type of retirement plan to the exclusion of 
other types. If an employer experiences financial difficulty, employ- 
ees with retirement savings concentrated primarily in employer 
stock may be subject to a double risk of loss. Not only would em- 
ployees lose their jobs (and employer contributions to their retire- 
ment plan possibly would be reduced or eliminated), but they also 
may suffer from decreases in the value of the securities and the 
amount of dividends paid thereon. Moreover, if a plan is permitted 
to invest substantially in employer securities, a plan fiduciary 
could be subject to great pressure to time purchases and sales to 
improve the market in those securities, whether or not the inter- 
ests of plan participants were adversely affected. 

Arguments against the proposals 

1. The tax incentives historically afforded ESOPs represent an 
attempt to balance tax policy goals encouraging employee stock 
ownership with those encouraging employer-provided retirement 
benefits. The special tax benefits for ESOPs are designed to encour- 
age the use of a special corporate financing tool (leveraged ESOPs) 
to expand the ownership of capital in the U.S. Leveraged ESOPs 
have a legitimate function as corporate financing devices. The cor- 
poration is able to obtain low-cost financing for plant expansion 
and other purposes, enabling it to become more productive, with 
the corporation's employees, rather than outside investors, receiv- 
ing the benefits. 

2. Employers who incur debt through an ESOP in order to pur- 
chase a block of employer securities to be held by the ESOP cannot 
reasonably be expected to retire the debt on a nondeductible basis. 
However, absent special deduction limits, an employer could not 
make deductible payments of interest and principal to retire the 
debt in many cases. 

3. Repeal of the special contribution and deduction limits for 
ESOPs would restrict investment in employer securities and, there- 
fore, would deny retirees the opportunity to benefit from growth in 
the value of employer securities. 



127 
Revenue Effect 

[Fiscal years, billions of dollars] 



Proposal 1988 1989 1990 1988-90 



Repeal special ESOP rules 0.1 0.2 0.2 0.5 



6. Accounting Provisions 

a. Accrual accounting requirement for large nonfarm busi- 
nesses 

Present Law 

In general, a nonfarm taxpayer must use an accrual method of 
accounting if the taxpayer's average annual gross receipts for any 
three-taxable year period preceding the year in question exceed $5 
million. Individuals, partnerships (other than partnerships having 
a C corporation as a partner), S corporations, and "qualified per- 
sonal service corporations" are exempt from the required use of an 
accrual method. 

A qualified personal service corporation is a corporation meeting 
a function test and an ownership test. The function test is met if 
substantially all the activities of the corporation are the perform- 
ance of services in the field of health, law, engineering, architec- 
ture, accounting, actuarial science, performing arts, or consulting. 
In general, the ownership test is met if substantially all of the 
value of the outstanding stock of the corporation is owned by 
present or retired employees. 

Possible Proposal 

Under the President's tax reform proposal, use of the cash 
method of accounting would have been denied to any taxpayer 
unless the taxpayer (1) had less than 5 million of gross receipts 
and (2) with respect to a trade or business other than farming, had 
not regularly used any other method of accounting for the purpose 
of reports or statements to shareholders, partners, other propri- 
etors, beneficiaries, or for credit purposes. No exception was provid- 
ed for individuals, partnerships, S corporations, or personal service 
corporations. (See section II. D. 7. a., below, for a discussion of ac- 
crual accounting proposals related to farming businesses.) 

Pros and Cons \ 

Arguments for the proposal 

1. An accrual method of accounting more properly reflects the 
economic income of a taxpayer. 

2. Although the simplicity of the cash method may justify its use 
by smaller, less sophisticated taxpayers, there is no sound policy 
reason to permit its use by larger businesses which have the capac- 
ity to deal with the additional burdens of accrual accounting. 

3. By allowing large taxpayers operating in certain business 
forms or in certain fields to use the cash method, present law per- 
mits distortion of income and the deferral of taxes by these taxpay- 
ers; it thus provides a subsidy to this group, discriminating against 

(128) 



129 

other similarly situated taxpayers, some of whom may be in direct 
competition with the exempted businesses. 

Arguments against the proposal 

1. Any benefits achieved by requiring these types of taxpayers to 
use the accrual method of accounting would be outweighed by the 
burdens of compliance. 

2. The cash method of accounting is more consistent with the 
manner in which professional partnerships and corporations con- 
duct their business and intra-partnership or intra-corporate affairs. 

Revenue Effect 

[Fiscal years, billions of dollars] 



Proposal 1988 1989 1990 1988-90 



Cash accounting denied for 
large nonfarm businesses 0.1 0.3 0.3 0.8 



b. LIFO method of inventory accounting 
Present Law 

Inventory methods 

Under present law, if the production, purchase, or sale of mer- 
chandise is a material income-producing factor to a taxpayer, the 
taxpayer is required to use an accrual method of accounting and to 
maintain inventories. Acceptable methods of accounting for inven- 
tories include specific identification, first-in first-out ("FIFO"), last- 
in first-out ("LIFO"), and, in certain limited circumstances, average 
cost. 

Under the LIFO method, the costs of the items most recently 
purchased or produced are matched against sales. When costs are 
rising, the LIFO method results in a higher measure of cost of 
goods sold and, consequently, a lower measure of taxable income. 
Thus, compared to the FIFO method, the LIFO method allows the 
recognition of taxable income to be deferred. Taxpayers are not re- 
quired to pay interest on the resultant deferral of tax liability. The 
extent of the deferral can be measured by the LIFO reserve, which 
is the excess of the taxpayer's LIFO inventory over the inventory 
that the taxpayer would be allowed under the FIFO method. 

The LIFO method is not permitted for purposes of measuring 
earnings and profits. In addition, recapture (i.e., inclusion in 
income) of the LIFO reserve is required in certain mergers and ac- 
quisitions. 

Interest charge on certain installment sales 

Present law (as amended by the 1986 Act) provides an election 
under which a dealer can avoid the application of the proportion- 
ate disallowance rule with respect to installment obligations that 
arise from certain sales of timeshares and residential lots. A dealer 
that makes this election with respect to an installment obligation 
is required to pay interest on any tax that is deferred as a result of 
payments on the obligation being received in any year following 
the year of sale. Interest is computed for the period from the date 
of the sale to the date the payment is received. The interest rate 
used for this purpose is 100 percent of the applicable Federal rate. 

Interest charge on long-term contracts 

A taxpayer using the percentage of completion method with re- 
spect to a long-term contract is required to determine upon comple- 
tion of the contract the amount of tax that would have been paid 
in each taxable year if the income from the contract had been com- 
puted by using the actual gross contract price and total contract 
costs, rather than the anticipated contract price and costs. Interest 
must be paid by the taxpayer if, applying this "lookback" method, 

(130) 



131 

there is an underpayment by the taxpayer with respect to a tax- 
able year. Similarly, under the "lookback" method, interest must 
be paid to the taxpayer by the Internal Revenue Service if there is 
an overpayment. The rate of interest for both underpayments and 
overpayments is the rate applicable to overpayments of tax (i.e., 
the short-term Federal rate plus two percentage points). 

Possible Proposals 

1. Repeal the LIFO method of inventory accounting. Require the 
LIFO reserve to be included in income ratably over a 10-year 
period. 

2. Similar to the interest charge on installment sales of time- 
shares and residential lots and the interest charge on the long-term 
contracts, require the payment of interest on the tax savings that 
result from the continued use of the LIFO method. Calculate the 
interest due for any year by applying the underpayment rate to the 
additional tax that would result if the LIFO reserve is included in 
income during such year. 

Pros and Cons 
Arguments for the proposals 

1. The use of the LIFO method results in an inappropriate defer- 
ral of tax especially during periods of high inflation. This deferral 
may extend for the life of the taxpayer. 

2. The LIFO method is inordinately complex, and may result in 
difficult audit problems for the Internal Revenue Service. To the 
extent that the Internal Revenue Service is unable to enforce the 
LIFO rules, taxpayers may prolong or increase the deferral bene- 
fits. 

3. The tax rate reduction in the 1986 Act provided a windfall to 
taxpayers that used the LIFO method to defer tax from pre- 1986 
years. 

Arguments against the proposals 

1. The LIFO method is considered by many as the most accurate 
measure of income during periods of inflation. The LIFO method is 
an acceptable method of accounting for financial statement pur- 
poses. 

2. The LIFO method has been simplified in the 1986 Act for 
small businesses. 



132 
Revenue Effect 

[Fiscal years, billions of dollars] 



Proposal 1988 1989 1990 1988-90 

(1) Repeal LIFO and amortize income 

change 2.6 4.6 4.7 11.9 

(2) Charge interest on LIFO reserves 1.5 2.6 2.7 6.7 



c. Accounting for long-term contracts 
Present Law 

Taxpayers engaged in the production of property under a long- 
term contract must compute income from the contract under either 
the percentage of completion method or the percentage of comple- 
tion-capitalized cost method. An exception is provided for certain 
small businesses with respect to contracts to be completed within 
two years. 

Under the percentage of completion method, the taxpayer must 
include in gross income for the taxable year an amount equal to 
the product of (1) the gross contract price and (2) the percentage of 
the contract completed during the taxable year. The percentage of 
a contract completed during the taxable year is determined by 
comparing costs incurred with respect to the contract during the 
year with the estimated total contract costs. In the taxable year in 
which the contract is completed, a determination is made whether 
the taxes paid with respect to the contract in each year of the con- 
tract were more or less than the amount that would have been 
paid if gross income had been computed by using the actual gross 
contract price and the actual total contract costs, rather than the 
anticipated contract price and costs. Interest must be paid by the 
taxpayer, if, applying this "lookback" method, there is an under- 
payment by the taxpayer with respect to a taxable year. Similarly, 
interest must be paid to the taxpayer by the Internal Revenue 
Service if there is an overpayment. 

Under the percentage of completion-capitalized cost method, the 
taxpayer must take into account 40 percent of the items with re- 
spect to the contract under the percentage of completion method. 
The remaining 60 percent of the items under the contract must be 
taken into account under the taxpayer's normal method of account- 
ing, for example, the completed contract method or an accrual 
method. Under the completed contract method, income from a con- 
tract is included and contract costs are deducted upon final comple- 
tion and acceptance of the contract. All costs that directly benefit 
or are incurred by reason of a taxpayer's long-term contract activi- 
ties must be allocated to its long-term contracts in the manner pro- 
vided in Treasury the regulations under section 451 for extended 
period long-term contracts. 

Possible Proposal 

Require 100 percent of all long-term contracts (other than con- 
tracts of small businesses exempted under present law) to be re- 
ported on the percentage of completion method. This could be ac- 
complished by immediate repeal of the completed contract method 

(133) 



134 

and other methods, or by phasing out the use of these methods 
over a period of years. 

Pros and Cons 
Arguments for the proposal 

1, The percentage of completion method is the only method that 
properly reflects the economic income of a taxpayer with respect to 
long-term contracts. The completed contract method, the accrual 
shipment method, and other similar methods permit an unwarrant- 
ed deferral of income from those contracts, and hence provide a 
subsidy to taxpayers allowed to use them. 

2. Virtually all taxpayers reporting income on the completed con- 
tract method for tax purposes use the percentage of completion 
method for financial reporting purposes. A business should not be 
allowed to report little or no income for tax purposes while report- 
ing large profits to its shareholders and creditors. 

Arguments against the proposal 

1. A taxpayer engaged in the performance of a long-term con- 
tract is generally not certain of the amount, if any, of the profit it 
will realize on the contract. It is therefore appropriate to deter- 
mine the amount of profit (or loss) when the contract is completed 
and accepted. 

2. A taxpayer has a right to the contract price only when the 
contract is completed or accepted. Thus, it "earns" any profit real- 
ized on a long-term contract only at that time, not on a proportion- 
ate basis over the term of the contract. 

3. In the absence of substantial progress payments in excess of 
out-of-pocket expenses, taxpayers may not have sufficient funds to 
pay tax prior to completion of the contract. 



135 
Revenue Effect 

[Fiscal years, billions of dollars] 



Proposal 1988 1989 1990 1988-90 

Completed contract method: 

(1) Require use of 100% per- 
centage of completion 
method for all long-term 
contracts for contracts en- 
tered into after December 

31,1987 0.4 1.4 2.2 4.0 

(2) Phase-in 100% percent- 
age of completion method 
for contracts entered into 
after December 31, 1986 
(60% in 1987, 80% in 
1988, 100% in 1989 and 

thereafter) 0.8 1.3 1.7 3.8 



d. Repeal of vacation pay reserve 
Present Law 

Under present law, an accrual-method taxpayer generally is per- 
mitted a deduction in the taxable year in which all of the events 
have occurred that determine the fact of a liability and the amount 
thereof can be determined with reasonable accuracy. Nonetheless, 
in order to ensure the proper matching of income and deductions 
in the case of deferred benefits for employees (such as vacation pay 
earned in the current taxable year, but paid in a subsequent year), 
an employer generally is entitled to claim a deduction in the tax- 
able year of the employer in which ends the taxable year of the 
employee in which the benefit is includible in gross income. Conse- 
quently, an employer generally is entitled to a deduction for vaca- 
tion pay in the taxable year of the employee for which the pay (1) 
vests (if the vacation pay plan is funded by the employer) or (2) is 
paid and for amounts which vest or are paid within 2 1/2 months 
after the end of the employer's taxable year. Under a special rule, 
an employer can elect to deduct an amount representing a reasona- 
ble addition to a reserve account for vacation pay earned by em- 
ployees before the close of the current year and paid by the close of 
that year or within 8-1/2 months thereafter. 

Possible Proposal 

The special rule that permits taxpayers a deduction for additions 
to a reserve for vacation pay could be repealed. Under this propos- 
al, deductions for vacation pay would be allowed in any taxable 
year for amounts paid, or funded amounts which vest, during the 
year or within 2-1/2 months after the end of the year. 

Pros and Cons 
Arguments for the proposal 

1. Allowance of a deduction prior to the time vacation pay is paid 
overstates the amount of the deduction because of the time value of 
money, thus, providing a tax subsidy for vacation pay relative to 
regular compensation. 

2. The reserve for vacation pay is an exception to the general 
rule of not allowing reserves for Federal income tax purposes. 

Argument against the proposal 

Allowing a deduction for vacation pay permits a more proper 
matching of the cost of providing vacation pay to the income that 
gave rise to the obligation to pay vacation pay. 



(136) 



137 
Revenue Effect 

[Fiscal years, billions of dollars] 



Proposal 1988 1989 1990 1988-90 

Repeal vacation pay reserve 0.1 0.1 (*) 0.2 

* Gain of less than $50 million. 



e. Limitations on deductibility of advertising costs 
Present Law 

A deduction is allowed for all ordinary and necessary business 
expenses paid or incurred during the taxable year in carrying on a 
trade or business. No deduction is allowed for capital expenditures, 
including the cost of acquiring an asset having a useful life that 
extends substantially beyond the taxable year. Selling expenses, in- 
cluding costs relating to advertising and promotion of a product, 
are treated as ordinary and necessary business expenses and hence 
are fully deductible in the year paid or incurred. 

Possible Proposals 

1. Require that all or a specified portion of advertising costs paid 
or incurred during a taxable year be amortized over some period of 
time, rather than deducted currently. 

2. Deny any deduction for advertising for, or promotion of, alco- 
hol and/or tobacco products. 

Pros and Cons 
Arguments for the proposal 

1. The benefit of amounts paid for advertising extend beyond the 
year of the expenditure. Requiring some portion of advertising 
costs to be deferred to a later year thus results in a more proper 
matching of the expenses with the income generated by them. 

2. Advertising expenditures do not lead to increase competitive- 
ness; they merely shift consumer buying priorities. Thus, there is 
no justification for a tax subsidy for these expenditures. 

3. Permitting a current deduction for advertising costs creates a 
preference for businesses that invest in advertising over businesses 
that invest in tangible assets or other types of intangible assets, 
the costs of which must be depreciated or amortized. 

4. Since it is difficult to determine precisely what portion of ad- 
vertising costs benefits a particular year, it is appropriate to pro- 
vide an assumed allocation of the benefit of such costs by statute. 

5. Limitations on advertising deductions will have very little 
effect on those corporations which had the biggest tax increases 
under the 1986 Act. Rather, they would affect those that received 
the highest benefits from rate reduction. 

6. Because of the adverse health effects of alcohol and tobacco 
products, it is inappropriate to allow a deduction for advertising 
and promoting them. 

Arguments against the proposal 

1. Advertising costs are costs of selling a product in the current 
taxable year, and do not create a separate and distinct asset having 

(138) 



139 

a life that extends substantially beyond the end of the year. Ac- 
cordingly, they should be fully deductible in the year incurred. 

2. Severe definitional and administrative problems will result in 
trying to differentiate between advertising and promotional ex- 
penses, on the one hand, and fully deductible selling expenses on 
the other hand. 

3. Even if some portion of advertising costs theoretically benefits 
future taxable years, it is only a de minimis amount. In any event, 
it is impossible to verify the degree or proper allocation of the ben- 
efit to future years. 

4. It is not appropriate tax policy to restrict the deductibility of 
advertising expenses while retaining expensing for similar expendi- 
tures such as research and development. 

5. Advertising provides a valuable service by providing informa- 
tion about prices and product quality that helps consumers make 
more informed decisions. 

6. It is inappropriate to use discriminatory tax provisions to deal 
with non-tax issues involving alcohol and tobacco. 

Revenue Effect 

[Fiscal years, billions of dollars] 



Proposal 


1988 


1989 


1990 


1988-90 


Advertising costs: 










(1) Overall— 










(a) Require a 4-year amor- 










tization of 20% of ad- 










vertising costs incurred 










during taxable years 


3.0 


4.5 


3.3 


10.8 


(b) Deny deduction for 










20% of corporate adver- 










tising costs and amor- 










tize remainder over 2 










years for firms over $5 










million of gross receipts.. 


12.7 


15.7 


9.5 


37.9 


(2) Deny advertising deduc- 










tion and promotion expense 










deduction for — 










(a) Tobacco products 


0.5 


0.8 


0.9 


2.2 


(b) Alcohol products 


0.3 


0.5 


0.6 


1.4 



f. Elimination of deferral of income of cooperatives 
Present Law 

Certain corporations are eligible to be treated as cooperatives 
and taxed under the special rules of subchapter T of the Code. In 
general, the subchapter T rules apply to any corporation operating 
on a cooperative basis (except mutual savings banks, insurance 
companies, most tax-exempt organizations, and certain utilities). 

In general, a cooperative may adopt any fiscal year as a taxable 
year. For Federal income tax purposes, a cooperative generally 
computes its taxable income as if it were a taxable corporation, 
with one important exception — the cooperative may deduct from its 
taxable income patronage dividends paid. In general, patronage 
dividends are profits of the cooperative that are rebated to its pa- 
trons pursuant to a preexisting obligation of the cooperative to do 
so. In computing its taxable income for a taxable year, the coopera- 
tive may deduct patronage dividends that are paid up to eight and 
one-half months after the close of the taxable year. 

Members of the cooperatives who receive patronage dividends 
must treat the dividends as income, reduction of basis, or some 
other treatment that is appropriately related to the type of trans- 
action that gave rise to the dividend. For example, where the coop- 
erative markets a product for one of its members, patronage divi- 
dends attributable to the marketing are treated as additional pro- 
ceeds from the sale of the product and are includible in the recipi- 
ent patron's income. Recipients of the patronage dividends general- 
ly take such dividends into account when received, even if the 
amounts are deducted by the cooperative in a prior period. 

Thus, under present law, income earned by a cooperative gener- 
ally is intended to be subject to one level of tax which is to be 
borne by the patron of the cooperative. Nevertheless, income 
earned by a cooperative may not be taxed to a patron until a 
period following the period in which the income was earned. This 
deferral may occur, for example, if the cooperative has a fiscal year 
and pays out its income for the fiscal year to calendar year taxpay- 
ers, but the distribution is during the portion of the fiscal year fol- 
lowing the close of the calendar year. 

Such deferral also may occur where the cooperative has a calen- 
dar year as a taxable year, but receives deductions for patronage 
dividends paid after the close of the calendar year while such divi- 
dends are taken into account by calendar year patrons only when 
received. Moreover, the period of deferral may be extended, in 
some cases for several years, where a cooperative pays patronage 
dividends to patrons that are themselves cooperatives. 

Various provisions of the Tax Reform Act of 1986 (the "1986 
Act") restricted the ability of other pass-through entities such as 
partnerships and trusts to use taxable years other than the calen- 

(140) 



141 

dar year in order to prevent deferral of tax by partners and benefi- 
ciaries. Other provisions of the 1986 Act Umited the deferral of 
income arising from the ability of regulated investment companies 
and real estate investment trusts to receive dividends paid deduc- 
tions for dividends paid after the end of the calendar year. 

Possible Proposal 

In order to prevent the deferral of income earned through a co- 
operative: 

1. all cooperatives could be required to adopt the calendar year 
as their taxable year; and 

2. cooperatives could be permitted to deduct patronage dividends 
only in the year that the dividends are paid. 

Pros and Cons 
Arguments for the proposals 

1. The proposal would require income that is earned by a cooper- 
ative to be recognized currently either by the cooperative or by its 
patrons. The "single tax" regime for cooperatives would be pre- 
served, since the cooperative would still receive a deduction at the 
time that patronage dividends are paid. 

2. The proposal would reduce the advantage of cooperatives that 
compete with investor owned business enterprises. 

3. The proposal is an extension of the provisions of the 1986 Act 
that attempted to limit the deferral of income through other pass- 
through entities. 

Arguments against the proposals 

1. Under the proposal, cooperatives would be required to distrib- 
ute all of their taxable income for a taxable year in order to avoid 
paying tax for that taxable year. To the extent that cooperatives 
distribute sufficient amounts to avoid paying tax, or to the extent 
that cooperatives actually pay tax, the amount of the cooperative's 
capital is diminished and would need to be replaced from other 
sources. This may be undesirable where the cooperative is not of a 
type that competes with investor owned business enterprises but 
rather is, for example, an entity used by small farmers to allow 
them to compete more effectively. 

2. The calendar year may not be a "natural business year" for 
certain cooperatives, and use of the calendar year may be incon- 
venient for such cooperatives. 



1 



g. Current accrual of market discount on bonds 
Present Law 

In general, present law requires inclusion of market discount on 
bonds only upon redemption or other disposition of the bond. Thus, 
a taxpayer who purchases a bond after original issue at a price less 
than its face amount (or adjusted issue price in the case of a bond 
originally issued at a discount) does not, absent an election, include 
in income any portion of the discount prior to disposition of the 
bond. Except in the case of tax-exempt obligations, market discount 
that accrues while the taxpayer holds such a bond is treated as or- 
dinary income upon the disposition of the bond up to the amount of 
gain realized. Interest on indebtedness incurred or continued to 
purchase or carry a bond with market discount is deferred to the 
extent that such interest does not exceed the market discount ac- 
cruing on the bond. Any interest expense so deferred is allowed 
when the market discount is recognized. 

Possible Proposals 

1. Require market discount on all bonds to be included currently 
as interest income by the holder as such discount accrues on an 
economic basis. Holders of discount bonds would know the amount 
of economic accrual of market discount by requiring brokerage 
firms (or other intermediaries) to provide relevant information to 
purchasers of market discount bonds. As an alternative to econom- 
ic accrual, the holder could be permitted to use a simplified method 
{e.g., straight line, proportional) for computing market discount al- 
locable to a period. 

2. Require current accrual only for market discount on bonds 
held by a defined class of "sophisticated" taxpayers, e.g., those that 
must accrue market discount on short-term obligations {i.e., banks, 
regulated investment companies, taxpayers using an accrual 
method of accounting and taxpayers holding obligations primarily 
for sale to customers in the ordinary course of the taxpayer's trade 
or business). 

Pros and Cons 
Arguments for the proposal 

1. From the holder's point of view, market discount is the eco- 
nomic equivalent of interest and is indistinguishable from original 
issue discount, which a holder must include in income on an 
annual basis. 

2. Requiring current inclusion of market discount would help cor- 
rect certain asymmetries in present law. For example, present law 
already permits acquisition premium to be deducted on a current 
basis. 

(142) 



143 

3. The proposal would eliminate the ability of taxpayers to offset, 
in effect, a capital loss against ordinary income, contrary to the 
general rules limiting the deductibility of capital losses. Where a 
bond that was purchased with market discount is later sold for an 
amount that is less than the taxpayer's original basis in the bond 
plus the amount of market discount that has accrued economically 
from the date of the acquisition, a portion of the accrued market 
discount (which is ordinary income) is offset by the capital loss re- 
sulting from decline in value of the bond. Under the proposal, the 
accrued market discount would be taken into account as ordinary 
income (with a corresponding increase in the taxpayer's basis in 
the bond) and any loss would be deductible as a capital loss. 

4. The proposals would eliminate the need for the complex rules 
requiring deferral of interest on debt attributable to market dis- 
count bonds. 

Arguments against the proposals 

1. Requiring current inclusion of market discount in income 
would interfere with the efficient operation of the capital markets. 

2. Holders of market discount bonds would be required to pay tax 
on income before cash is actually received, creating liquidity prob- 
lems. 

3. Unless the proposal is limited to sophisticated taxpayers or 
broad reporting requirements are imposed on brokerage houses to 
provide the holder (and the Internal Revenue Service) with the 
amount of discount that must be included in income, the proposals 
may be difficult to administer for both the holder, since the compu- 
tation of the amount of accrued income on an economic basis is 
complex, and the Internal Revenue Service, since the Service does 
not presently receive information relating to the purchase of bonds 
in the secondary market. 



h. Installment sales 

Present Law 

Under present law, a taxpayer who sells property ordinarily 
must recognize gain or loss at the time of the sale. However, a tax- 
payer who is eligible to use the installment method may defer the 
payment of tax and recognize gain from a sale of property in pro- 
portion to the payments received. 

In general, the installment method may be used to report gam 
from the sale of personal property on the installment plan by deal- 
ers in personal property who regularly sell on the installment plan, 
or for other sales of property where at least one payment is to be 
made after the end of the taxable year in which the sale is made. 

Use of the installment method is generally limited under the so- 
called "proportionate disallowance rule" for dealer sales of real 
property and dealer sales of personal property eligible to be report- 
ed on the installment method, as well as for sales of real property 
used in the taxpayer's trade or business or held for the production 
of rental income where the selling price of such real property is 
greater than $150,000. Under the proportionate disallowance rule, 
a pro rata portion of the taxpayer's indebtedness is allocated to, 
and is treated as a payment on, the installment obligations of the 

taxpayer. , ^ i ^ 

Use of the installment method is not allowed for sales pursuant 
to a revolving credit plan and for sales of publicly traded property. 
In addition, the installment method may not be used for purposes 
of the alternative minimum tax for sales that are subject to the 
proportionate disallowance rule. 

At the election of the seller, installment obligations arising from 
certain sales of residential lots and "timeshares" are not subject to 
the proportionate disallowance rule. Rather, such taxpayers may 
compute their tax liability under the installment method and are 
required to pay interest on the amount of deferred tax attributable 
to the use of the installment method. 

Possible Proposals 

1. Use of the installment method would be repealed for all sales 
by dealers and for all non-dealer sales that are subject to the pro- 
portionate disallowance rule. 

2. Same as proposal 1, except that, for non-dealer sales, payment 
of the tax due on account of the sale may be deferred for an appro- 
priate period with an appropriate interest charge. 

(144) 



145 

Pros and Cons 
Arguments for the proposals 

1. Repeal of the installment method would result in income being 
measured more accurately by both dealers and non-dealers, and 
would result in application of the same rules for regular tax pur- 
poses as are applied for alternative minimum tax purposes. 

2. Repeal of the installment method would eliminate the need to 
apply the complicated provisions of the proportionate disallowance 
rule. 

3. Liquidity problems are more likely to occur in the case of non- 
dealer sales than in the case of dealer sales. Hence, an exception 
under which tax may be deferred with interest should be made for 
such sales. 

Arguments against the proposals 

1. Both dealers and non-dealers suffer the same liquidity prob- 
lems that the use of the installment method is intended to allevi- 
ate. 

2. The proportionate disallowance rule is an appropriate limita- 
tion on the use of the installment method because it generally re- 
flects the extent to which the seller has received cash. 



i. Amortization of intangibles 

Present Law 

Taxpayers may take depreciation or amortization deductions for 
the exhaustion, wear, tear, and obsolescence of property (sec. 
167(a)). No such deductions are allowed, however, with respect to 
property that is not a wasting asset or property whose useful life 
cannot be estimated with reasonable accuracy. Deductions are gen- 
erally allowed for the costs attributed to such intangible assets as 
patents or other statutory or contract rights that exist for a specif- 
ic, non-extendible period of time. However, because goodwill does 
not have a determinable useful life, no depreciation deduction is al- 
lowed with respect to that intangible asset. Accordingly, the por- 
tion of the purchase price of a business that is allocated to goodwill 
may not be amortized or depreciated. Goodwill has been defined as 
the expectancy of continued patronage, for whatever reason, or as 
"the probability that old customers will resort to the old place". 

Taxpayers frequently take the position that a substantial portion 
of the purchase price of a business is allocable to certain intangible 
assets other than goodwill, for which they attempt to establish a. 
limited useful life and claim depreciation. The value of such other 
assets is often described as the value obtained from the existing 
customer base and the useful life is often said to be the time period 
over which that base may erode as customers move away or with- 
draw their level of patronage. Such assets include, for example, 
customer and subscription lists; patient or other client records; the 
existing "core" deposits of banks; insurance in force in the case of 
an insurance company; advertising relationships and customer or 
circulation base in the case of a broadcast or newspaper business; 
and existing market share in the case of any business. 

In many instance, courts have refused to permit the amortization 
of such assets. The IRS has successfully argued that these items 
may be viewed as "mass assets" in that particular customers may 
be lost but others may be expected to replace them. Deductions 
have also been denied in many cases for such intangible assets as 
customer or client information that facilitates the business of serv- 
ing customers. Such records have been described as simply an inte- 
gral part of the goodwill of the business. 

In some other cases, however, courts have permitted deductions 
for such items as customer lists or client information, stating that 
such assets are of use primarily as a resource for serving customers 
of the business but are not the same as goodwill. Still other cases 
have denied the deductions claimed in the particular case, but have 
suggested that if the taxpayers had presented better statistical evi- 
dence of the period over which the existing customer base declined, 
amortization might be permitted. The cases permitting or suggest- 
ing the possibility of a deduction have not always indicated wheth- 

(146) 



147 

er it is necessary to take into account any expectation or evidence 
that new customers will replace those that die, move away, or oth- 
erwise sever their customer relationships. 

Generally, costs attributable to the creation or acquisition of an 
asset that has a useful life of more than a year may not be current- 
ly deducted, but must be capitalized. Goodwill typically would have 
a life extending beyond one year and costs that can be related to 
,1 its creation, such as those of certain extraordinary advertising cam- 
paigns, are required to be capitalized. However, it is possible that 
]|many taxpayers deduct currently costs that may contribute to the 
I creation of goodwill, such as ordinary advertising or other ongoing 
(business expenses. This may occur in part because of the difficul- 
jlties of separately identifying which ordinary and necessary busi- 
ness expenses have created goodwill, and of determining when or 
whether "new" goodwill has been created. 

Possible Proposals 

1. Deny amortization or depreciation deductions for intangible 
assets representing the value of the existing customer base or 
market share. 

2. Permit amortization of such intangible assets if a deduction 
might arguably be claimed under present law, but permit the de- 
duction only over a uniform, prescribed period of substantial dura- 
tion (e.g., 40 years). 

Pros and Cons 
Arguments for the proposals 

1. Assets similar to goodwill, such as intangible assets reflecting 
the value of a customer base or market share should not be amor- 
tized more rapidly than goodwill. 

2. The key factors that make goodwill a nondepreciable asset are 
also present in the case of other intangible assets representing the 
value of the customer base or market share. One is the difficulty of 
determining a useful life. Although it is possible that goodwill may 
diminish over time if it is not continually renewed, it is extremely 
difficult to determine the extent to which "old" goodwill is retained 
or "new" goodwill is created, through ongoing business operations. 
This difficulty exists as well for other assets related to the value of 
the customer base or market share. Likewise, taxpayers that seek 
to amortize the costs of acquiring such intangibles, on the grounds 
that they are "wasting" assets with a determinable useful life ex- 
tending beyond a year, may be capitalizing little if any of their on- 
going business expenses as costs of creating the new "customer" 
base or market share that replaces the one that they have written 
off. 

Arguments against the proposals 

1. Present law with respect to goodwill may be unduly restrictive 
because goodwill may erode over time if it is not continually re- 
newed. Taxpayers should thus be permitted to accomplish a result 
similar to a deduction for goodwill by attempting to establish a de- 



148 

terminable useful life for such significant portion of the intangible 
asset value related to customer base or market share, ! 

2. Taxpayers should not be precluded from attempting to estab- 
lish a limited useful life for any asset. 



Revenue Effect 

[Fiscal years, billions of dollars] 



Proposal 


1988 


1989 


1990 


1988-90 


Amortization of intangibles 


(M 


(^) 


(') 


0.1 





^ Gain of less than $50 million. 



j. Disallow interest deductions allocable to tax-exempt in- 
stallment sales of property to State or local govern- 
ments 

Present Law 
Installment sales to State and local governments 

Under present law, if a taxpayer sells property to a State or local 
government in exchange for an installment obligation, interest on 
the obligation may be exempt from tax. 

If an installment obligation is received in exchange for certain 
types of property (including most dealer property and certain real 
property held for use in a trade or business or for the production of 
rental income), then use of the installment method by the seller is 
limited under a formula that allocates a portion of the taxpayer's 
indebtedness among the taxpayer's installment obligations. 

Disallowance of interest deductions 

Present law provides that no deduction is allowed for interest on 
indebtedness incurred or continued to purchase or carry obligations 
the interest on which is not subject to tax. 

Under present law, in the case of a corporation other than a fi- 
nancial institution or a dealer in tax-exempt obligations, interest 
on the corporation's indebtedness generally is not disallowed where 
during a taxable year the average amount of the corporation's tax- 
exempt obligations does not exceed 2 percent of the average total 
assets held in the active conduct of a trade or business. In many 
cases, such taxpayers may hold tax-exempt obligations that exceed 
2 percent of their assets, yet take the position that none of their 
interest expense is disallowed. 

For example, such taxpayers may rely on an Internal Revenue 
Service ruling (Revenue Procedure 72-18) under which interest on 
such a corporation's indebtedness is not disallowed where the cor- 
poration acquires nonnegotiable tax-exempt obligations in the ordi- 
nary course of business for services performed for, or goods sup- 
plied to. State or local governments. Although the IRS has issued a 
private letter ruling indicating that a tax-exempt obligation would 
be treated as nonnegotiable for these purposes only if the obliga- 
tion cannot be sold, many taxpayers take the position that nonne- 
gotiable obligations are those obligations that are so treated under 
the Uniform Commercial Code (U.C.C). 

Present law provides that, in the case of a financial institution, 
no deduction is allowed for the portion of interest expense that is 
allocable to tax-exempt interest. In general, the allocation of the 
interest expense of the financial institution for this purpose is 
based on the ratio of the average adjusted bases of the tax-exempt 

(149) 



150 



1 



obligations acquired after August 7, 1986, to the average adjusted 
bases of all assets of the taxpayer. 

Possible Proposals 

1. Where a taxpayer sells property to a State or local govern- 
ment and receives an obligation of such government the interest on 
which is exempt from tax, a portion of the taxpayer's interest de- 
ductions could be denied based on an allocation of the taxpayer's 
indebtedness to such obligation. The denial could or could not be 
dependent upon whether the taxpayer accounts for its income with 
respect to the sale on the installment method. 

The allocation of the taxpayer's debt to the obligations received 
from the State or local government could be based on either a pro 
rata allocation among the taxpayer's assets determined on a yearly 
basis, or based on the somewhat different allocation formula em- 
ployed for purposes of limiting the use of the installment method. 

2. The IRS position, that a tax-exempt obligation must be nonsa- 
leable in order to be treated as nonnegotiable, could be codified. In 
addition, the 2-percent de minimis rule could be repealed. 

Pros and Cons 
Arguments for the proposals 

1. In general, permitting the holding of tax-exempt obligations 
without limiting the deductibility of interest expense may be 
viewed as a tax subsidy. This tax subsidy may create a competitive 
advantage for large manufacturers who sell equipment to State 
and local government over taxpayers who are either smaller in size 
or who only provide financing for State and local governments to 
purchase equipment (and are therefore less likely to benefit from 
the 2 percent de minimis exception). 

2. Pro rata allocation of indebtedness among assets (either in the 
manner prescribed for financial institutions or for purposes of the 
installment sale rules) avoids the difficult and often subjective in- 
quiry relating to when indebtedness is incurred or continued to 
purchase or carry tax-exempt obligations. If the taxpayer uses the 
installment method to account for gain from the sale to the State 
or local government, the taxpayer already may be required to allo- 
cate indebtedness to the installment obligation in the manner pre- 
scribed by the installment sale rules. 

3. The original exception for nonnegotiable instruments was in- 
tended for a narrower class of obligations than those that are non- 
negotiable under the U.C.C. (which was not in effect at the time 
that the exception was carved out). 

Arguments against the proposals 

1. To the extent that the benefit of any tax subsidy is passed 
along to the State or local government, the proposal may have the 
effect of raising the financing costs for a State or local government 
in the same manner as partially or fully taxing the interest on the 
government's obligation. 

2. The proposal to allocate debt among tax-exempt obligations re- 
ceived in exchange for property sold by the taxpayer may have the 



151 

effect of denying interest deductions on indebtedness if a taxpayer 
sells property to a State or local government, where the deductions 
would not be denied if the taxpayer simply purchased for cash an 
obligation of the State or local government the interest on which 
was exempt from tax. 

Revenue Effect 

[Fiscal years, billions of dollars] 



Proposal 


1988 


1989 


1990 


1988-90 


Apply section 265 to installment 
sales to State and local gov- 
ernments 


(^) 


0.1 


0.1 


0.2 



Gain of less than $50 million. 



74-267 0-87-6 



k. Below-market loans to certain continuing care facilities 
Present Law 

Under present law, certain loans that bear interest at below- 
market rates are treated as loans that bear interest at a market 
rate accompanied by a payment from the lender to the borrower 
that is characterized in accordance with the substance of the par- 
ticular transaction (e.g., gift, compensation, dividend, etc.). The 
market rate used for this purpose is determined by reference to 
market yields on Treasury obligations of similar maturity. 

The rules relating to below-market loans apply to (1) loans where 
the foregone interest is in the nature of a gift, (2) loans to an em- 
ployee from an employer or to an independent contractor from one 
for whom the independent contractor provides services, (3) loans 
between a corporation and a shareholder of the corporation, (4) 
loans of which one of the principal purposes is the avoidance of any 
Federal tax, and (5) to the extent provided in Treasury regulations, 
any below-market loan if the interest arrangement of such loan 
has a significant effect on any Federal tax liability of either the 
lender or the borrower. 

An exception from the below-market loan rules is provided for 
certain loans to certain "continuing care facilities." In exchange 
for the making of such below-market loans, individual lenders may 
receive housing, meals and other personal consumption items in 
addition to a promise of long-term nursing care if necessary. 

Possible Proposal 

Provide that below-market loan rules apply to below-market 
loans to continuing care facilities and other similar facilities that 
provide consumption items in connection with the making of a 
below-market loan. 

Pros and Cons 
Arguments for the proposal 

1. Below-market loans to continuing care or like facilities may 
have the effect of allowing individuals to avoid tax on income that 
is used to pay for certain items. 

2. Continuing care or like facilities that raise capital in the form 
of below-market loans have a competitive advantage compared to 
comparable facilities that raise capital by more traditional means. 

Argument against the proposal 

Continuing care facilities and other similar facilities provide a 
valuable service to elderly persons who wish to provide for present 
or possible future long-term care needs, and should be encouraged 
by permitting the use of below-market loans. 

(152) 



153 
Revenue Effect 

[Fiscal years, billions of dollars] 



Proposal 1988 1989 1990 1988-90 

Below-market loans to certain 
continuing care facilities (^) (^) (^) (^) 

^ Gain of less than $50 million. 



7. Farming Provisions 

a. Accrual accounting requirement for large farming busi- 
nesses 

Present Law 

In general, taxpayers required to maintain inventories for a par- 
ticular trade or business must use an accrual method of accounting 
for that trade or business. A taxpayer is required to maintain in- 
ventories for a trade or business if the production, purchase, or sale 
of goods is an income-producing factor. 

Special rules apply in the case of taxpayers engaged in the trade 
or business of farming. Such taxpayers generally may use the cash 
receipts and disbursements method of accounting for the business 
even though it involves the production and sale of goods. However, 
if the taxpayer is a corporation (other than an S corporation or a 
family-owned C corporation) or is a partnership with a corporate 
partner and has gross receipts of more than $1 million for any tax- 
able year beginning after 1975, an accrual method must be used. In 
general, a family-owned corporation is one 50 percent or more of 
whose stock is owned by members of the same family. Certain 
closely held corporations substantially owned by two or three fami- 
lies on October 4, 1976, and at all times thereafter also qualify as 
family-owned for purposes of this exception. 

Separate rules require use of an accrual method of accounting by 
any C corporation or partnership having a C corporation as a part- 
ner — without regard to whether the taxpayer is required to main- 
tain inventories — if the taxpayer's average annual gross receipts 
for the three-taxable year period ending with the year exceed $5 
million. These rules do not apply, however, if the taxpayer is en- 
gaged in the trade or business of farming or raising timber or orna- 
mental trees that are more than six years old at the time severed 
from the roots. Use of an accrual method is required without 
regard to gross receipts, and notwithstanding the fact that it is en- 
gaged in farming, if the taxpayer is a tax shelter. 

Possible Proposals 

1. Under the President's tax reform proposal, use of the cash 
method of accounting would have been denied to a farming busi- 
ness unless the taxpayer has less than $5 million of gross receipts 
test. (This rule would have applied in addition to the rules requir- 
ing use of an accrual method by farming corporations or partner- 
ships having a corporate partner.) 

2. Use of the cash method of accounting could be denied to tax- 
payer's annual gross receipts exceed $50 or $100 million. 

(154) 



155 

Pros and Cons 
Arguments for the proposals 

1. Allowing taxpayers engaged in farming to use the cash method 
of accounting distorts their income and permits a deferral of taxes. 
Although the simplicity of the cash method may justify its use by 
smaller, less sophisticated taxpayers, there is no sound policy 
reason to permit its use by larger farming businesses which have 
the capacity to deal with the additional burdens of accrual account- 
ing. 

2. Allowing use of the cash method by large farming businesses 
that happen to be family-owned acts as a subsidy to these business- 
es and gives them an advantage over other corporations of the 
same size that are in direct competition with them. 

Argument against the proposals 

The subsidy provided to farming businesses by allowing them to 
use the cash method serves social and economic objectives. Specifi- 
cally, it helps to insulate these businesses and, in some cases, 
smaller farms working for them under contract, from fluctuations 
in the world market for farm products. 

Revenue Effect 

[Fiscal years, billions of dollars] 
Proposal 1 1988 1989 1990 1988-90 

Cash accounting: 
Repeal for farms with gross 
receipts over — 

(1) $100 million 0.1 0.1 0.1 0.3 

(2) $50 million 0.1 0.2 0.2 0.5 

(3) $5 million (President's 

tax reform proposal) 0.2 0.3 0.3 0.8 

1 All proposals would be effective for taxable years beginning after December 31, 

1987. 



b. Treat farm losses like real estate losses under the passive 
loss rules 

Present Law 

Present law, as amended by the 1986 Act, provides that deduc- 
tions from passive trade or business activities, to the extent they 
exceed income from all such passive activities (exclusive of portfo- 
lio income), generally may not be deducted against other income. 
Suspended losses are carried forward and treated as deductions 
from passive activities in the next year. Suspended losses are al- 
lowed in full when the taxpayer disposes of his entire interest in 
the activity to an unrelated party in a transaction in which all re- 
alized gain or loss is recognized. The provision applies to individ- 
uals, estates, trusts, and personal service corporations. A special 
rule limits the use of passive activity losses and credits against 
portfolio income in the case of closely held corporations. 

An activity generally is treated as passive if the taxpayer does 
not materially participate in it, i.e. the taxpayer is not involved in 
the operations of the activity on a basis which is regular, continu- 
ous, and substantial. Retired farmers and surviving spouses of 
farmers generally are treated as continuing to materially partici- 
pate after retirement or death, as the case may be. 

Rental activities are defined as passive activities, without regard 
to material participation. A special rule provides that up to $25,000 
of losses and (deduction equivalent) credits from a rental real 
estate activity (generally, one in which the taxpayer actively par- 
ticipates) are allowed against other income for the year. The 
$25,000 amount is phased out between $100,000 and $150,000 of ad- 
justed gross income. 

Possible Proposal 

Losses from farming activities could be treated in the same 
manner as losses from rental activities. Thus, farm losses would be 
treated as losses from passive activities for purposes of the passive 
loss rule and could not offset income from other activities prior to 
the time the farming activity is disposed of. An exception similar to 
the allowance of up to $25,000 of losses from certain rental real 
estate activities could allow individuals who materially participate 
(within the meaning of the passive loss rule) in the farming activi- 
ty to offset up to $25,000 of non-farm income, with a phase-out of 
the $25,000 amount between $100,000 and $150,000 adjusted gross 
income. 



(156) 



157 

Pros and Cons 
Arguments for the proposal 

1. Until a taxpayer disposes of his or her interest in a farming 
activity, the losses may not represent economic losses (because of 
the use of the cash method of accounting or other tax preferences) 
and should not be allowed to offset other income. 

2. High-income taxpayers often offset non-farm business income 
with farming losses and thereby avoid paying substantial income 
tax. 

3. The ability of high income individuals to use immediately 
farm tax losses to offset other income may give time an unfair ad- 
vantage in competing with real farmers and distort the farm econo- 
my. The allowance of up to $25,000 of losses against nonfarm 
income will be sufficient for the person whose main livelihood is 
farming. 

Arguments against the proposal 

1. Farming is a risky business in which many individuals lose 
money and those losses should be allowed to offset other income 
prior to disposing of the farm. 

2. Unlike rental activities, farming is a labor-intensive business 
in which services of the taxpayer are likely to be a material income 
producing factor. Thus, the rationale for treating rental activities 
generally as passive should not apply to farming. 

3. Farming operations should not be discouraged by tax law limi- 
tations. 

Revenue Effect 

[Fiscal years, billions of dollars] 



Proposal 


1988 


1989 


1990 


1988-90 


Treat farm losses like real 
estate losses under the pas- 
sive loss rules 


0.4 


1.2 


1.4 


3.0 







i 



c. Increase cost recovery period for single-purpose agricul- 
tural structures 

Present Law 

For purposes of ACRS and the alternative depreciation system, 
single-purpose agricultural and horticultural structures (described 
in ADR class 01.3) are assigned an ADR midpoint life of 15 years. 
As a result of assigning a 15-year midpoint, the cost of this proper- 
ty is recovered over seven years under ACRS. 

Possible Proposal 

Under ACRS, the cost of single-purpose agricultural and horticul- 
tural structures (except greenhouses and mushroom houses) could 
be recovered over 15 years. 

Argument for the proposal 

Under the ADR system, farm buildings were assigned an ADR 
midpoint of 25 years. Under the general rules, the cost of property 
with an ADR midpoint of 25 years is recovered over 20 years. Pro- 
viding a special, accelerated recovery period for such structures en- 
courages tax-shelter motivated investment in the farming sector. 
Such investment hinders, rather than assists, family farming ac- 
tivities. 

Argument against the proposal 

The high-risk nature of many of the farming activities (e.g., 
chicken farming) in which single-purpose agricultural structures 
are used necessitates continuation of preferential subsidies. 

Revenue Effect 

[Fiscal years, billions of dollars] 
Proposal 1988 1989 1990 1988-90 

Increase cost recovery period for 
single-purpose agriculture 
structures to 15 years (^) (^) (^) (^) 

^ Gain of less than $50 million. 



(158) 



8. Financial Institutions 

a. Repeal tax-exempt status of credit unions 

Present Law 

Credit unions are exempt from Federal income tax under present 
law. This exemption applies regardless of whether, or to what 
extent, income of the credit union is distributed as dividends. Both 
State and Federally chartered credit unions are exempt from tax. 

Possible Proposal 

Under the President's 1985 tax reform proposal, the tax exemp- 
tion would have been repealed for credit unions having assets of $5 
million or more. 

! Credit unions could be taxed in a manner similar to thrift insti- 
tutions (e.g., savings and loans and mutual savings banks). Re- 
I tained earnings of a taxable credit union (i.e., earnings not distrib- 
! uted as dividends to members) v/ould be subject to tax at the credit 
j union level, while dividends would (as under present law) be tax- 
' able upon receipt by individual members. Alternatively, a specified 
amount of credit union income could be exempt from tax. 
i 

Pros and Cons 

i Arguments for the proposal 

1. Credit unions, especially larger credit unions, offer services 
similar to those provided by other financial institutions. Allowing 
them to be tax-exempt provides an unfair competitive advantage. 

2. The Tax Reform Act of 1986 significantly reduced the tax ad- 
vantages enjoyed by other financial institutions, thereby making 
credit unions have an even larger competitive advantage. 

Arguments against the proposal 

1. Credit unions are distinguished from other financial institu- 
tions, because they are more directly controlled by their members, 
and generally are limited to making consumer loans. 

2. Tax exemption enables credit unions to act in the interest of 
their members, rather than seeking higher returns in other, possi- 
bly riskier ventures. 



(159) 



160 
Revenue Effect 



[Fiscal years, billions of dollars] 






Proposal 1988 1989 


1990 


1988-90 ( 


Repeal tax-exempt status of 
credit unions 0.2 0.4 


0.4 


1.0 






( 



b. Tax treatment of recoveries of bad debts of thrift institu- 
tions 

Present Law 

Present law provides that no gain or loss (including any bad 
debt) is recognized by a thrift institution where it forecloses on 
property or acquires property that was security for a loan. Any 
gain or loss on the disposition of such property is treated as having 
the same character as that of the loan. Finally, present law pro- 
vides that "any amount realized . . . with respect to such property 
shall be treated . . . as a payment on account of such indebtedness. 

In Gihralter Financial Corporation of California v. United States, 
86-1 U.S.T.C. par. 9405 (Ct.Cl. May 9, 1986), the Court of Claims 
held that the full amount realized on the sale of property acquired 
by a thrift institution by foreclosure reduces the amount of the re- 
serve for bad debts rather than reducing the reserve by the amount 
of the loan and recognizing income on the excess of the amount re- 
alized over the amount of the loan. 

Thrift institutions may compute the addition to the reserve for 
bad debts under one of two methods. Under the experience method, 
an addition to the reserve for bad debts is permitted to increase the 
balance of the reserve at the end of the taxable year to a set dollar 
amount. Thus, amounts added to the reserve from dispositions of 
property acquired by foreclosure would reduce the amount of de- 
duction permitted for additions to the reserve under the experience 
method. Under the percentage of taxable income method, the addi- 
tion to the reserve for bad debts is 8 percent of the taxable income 
of the thrift institution. Since the addition to the reserve for bad 
debts under this method generally is computed by reference to the 
taxable income of the thrift institution, the size of the reserve does 
not affect the amount of the bad debt deduction for additions to the 
reserve. 

Possible Proposal 

Amounts realized on the disposition of property acquired by a 
thrift institution by foreclosure or which secured a loan owed to 
the thrift institution would be added to the reserve for bad debts 
only to the extent of the basis of the thrift institution in the loan. 
Amounts realized in excess of the basis of the loan would be treat- 
ed as ordinary income. 

Pros and Cons 

Argument for the proposal 

By allowing amounts to be charged to the reserve for bad debts 
in excess of the amount of the loan, the court in the Gibralter Fi- 

(161) 



162 

nancial Corporation case effectively would exempt gain on the sale 
of foreclosed property from taxation for thrift institutions using the \ 
percentage of taxable income method for computing the addition to 
the reserve for bad debts. 

For example, where a thrift institution made a mortgage loan of 
$100 to finance the purchase of a residence, later acquired the 
mortgaged property in a foreclosure sale, and subsequently sold the 
property for $125, the thrift institution realized a gain of $25. 
Nonetheless, that gain would not be taxed because, under the Gil- 
bralter Financial Corporation case, the full amount of the $125 
sales proceeds would be added to the reserve for bad debts and the 
dollar amount of the reserve does not affect the bad debt deduction 
of the thrift institution if it used the percentage of taxable income 
method. 

Argument against the proposal 

Adoption of the proposal would increase the income taxes of i 
thrift institutions which are currently in a state of financial hard- i 
ship. ' 

Revenue Effect 

[Fiscal years, billions of dollars] 



Proposal 


1988 


1989 


1990 


1988-90 


Tax treatment of recoveries of 
bad debt of thrift institutions.... 


(^) 


(1) 


0.1 


0.1 



Gain of less than $50 million. 



9. Corporate Provisions 

a. Intercorporate dividends received deduction 

Present Law 

Under present law, corporations are entitled to a deduction equal 
to 80 percent of the dividends received from a domestic corpora- 
tion. This results in a maximum effective tax rate (after 1987) of 
6.8 percent on such intercorporate dividends. Dividends received 
from a subsidiary in which the distributee owns an 80-percent or 
more interest or from a small business investment company are 
fully deductible by the distributee. Dividends received from a cor- 
poration with which the distributee files a consolidated return are 
"eliminated" (that is, disregarded) in computing consolidated tax- 
able income. 

Special anti-abuse rules deny or reduce the benefit of the divi- 
dends received deduction in certain circumstances. The deduction 
is not available with respect to dividends received on stock that is 
not held with a substantial risk of loss for a specified period, gener- 
ally more than 45 days (90 days in the case of certain distributions 
of preferred stock). The deduction is also denied to the extent the 
dividends are attributable to debt-financed portfolio stock. Portfolio 
stock for this purpose is stock representing less than 50 percent of 
the voting power and value of all stock in the corporation, but ex- 
cluding certain stock in corporate joint ventures. 

Finally, a corporate shareholder's basis in stock is reduced by the 
portion of a dividend eligible for the dividends received deduction if 
the dividend is "extraordinary." In general, a dividend is extraordi- 
nary if the amount of the dividend equals or exceeds 10 percent (5 
percent in the case of preferred stock) of the shareholder's adjusted 
basis in the stock and the shareholder has not held the stock, sub- 
ject to a risk of loss, for at least 2 years prior to the earlier of the 
date the dividend is declared, announced, or agreed to. 

Possible Proposals 

1. The deduction for intercorporate dividends could be eliminated 
for distributions with respect to newly issued (alternatively, newly 
acquired) stock that does not rise to the level of a direct investment 
in the underlying business. For example, the deduction might be 
denied unless the distributee's stock ownership exceeds some speci- 
fied percentage (e.g., 10 or 20 percent) of the value and voting 
power of the distributing corporation. 

2. The 80-percent dividends received deduction might be reduced 
to 75 percent, or some other percentage, of the amount of the divi- 
dend, or phased out entirely. 

(163) 



164 

Pros and Cons 
Arguments for the proposals 

1. The most appropriate rationale for the dividends received de- 
duction is that the distributing corporation is the corporate alter 
ego of the distributee corporate shareholder; i.e., the distributing 
corporation's earnings are indirectly those of the shareholder. This 
is a valid assumption only where the shareholder's interest in the 
distributing corporation is substantial. In the absence of such a 
substantial interest, dividends received by one corporation from an- 
other are indistinguishable from interest income or any type of 
income from an unrelated corporation. Furthermore, it is anoma- 
lous not to tax such dividends while gain recognized on a sale of 
stock (which may simply reflect undistributed earnings) is taxable. 

2. Allowing the deduction for dividends on portfolio stock may 
cause distortions in the stock market and create a windfall for the 
corporate shareholder. Although the price that is paid by a corpo- 
rate investor when it purchases stock is fixed by a market that in- 
cludes fully taxable individual purchasers, a corporate shareholder 
receives a return on stock that is not fully taxable to it, but rather 
is taxed at a msiximum rate of 6.8 percent. 

3. The dividends received deduction may confer an unintended 
benefit in many cases. While it was intended to assure that earn- 
ings generally are taxed only once at the corporate level, the de- 
duction is available whether or not the distributed earnings were 
taxed to the distributing corporation. Thus, the deduction may 
result in no corporate-level tax being paid. Allowance of the divi- 
dends received deduction for porfolio stock thus in effect permits 
tax benefit transfers among corporations. An issuing corporation 
that has net operating losses (and hence is unable to use additional 
interest deductions) may issue preferred stock to corporate share- 
holders in lieu of debt with a taxable yield. The preferred stock 
will sell at a higher price because of its low-tax return. In many 
cases such stock can be structured to have the economic and legal 
characteristics of debt. 

4. The dividends received deduction creates incentives for corpo- 
rations to engage in tax arbitrage transactions, necessitating com- 
plex anti-abuse provisions in the Code. These provisions are only 
partially successful in preventing such transactions. 

Arguments against the proposals 

1. The dividends received deduction is desirable to avoid (or mini- 
mize) multiple taxation of earnings at the corporate level. The ra- 
tionale of the deduction, that corporate earnings should be taxed 
only once at the corporate level, is applicable irrespective of wheth- 
er the corporate shareholder has a minimal or a substantial inter- 
est in the distributing corporation. 

2. It is appropriate to provide a dividends received deduction 
without regard to whether the earnings were taxed to the distribut- 
ing corporation. This permits the benefit of tax incentives such as 
accelerated depreciation to be enjoyed so long as earnings remain 
in corporate solution. This rationale should apply without regard to 
whether the earnings are distributed outside the group of corporate 
shareholders that has a direct investment in the activity. 



165 

3. Any windfall to corporate shareholders from a tax-free return 
may be diminished to the extent the market price of the stock is 
set by a market that includes tax-exempt investors. 

Revenue Effect 

[Fiscal years, billions of dollars] 
Proposal 1988 1989 1990 1988-90 

Intercorporate dividends re- 
ceived deduction changed from 
80 percent to 75 percent 0.1 0.2 0.3 0.6 



b. Modify computation of earnings and profits for intercor- 
porate dividends and basis adjustments (Woods Invest- 
ment Company) 

Present Law 

In 1966, the Treasury Department issued consolidated return reg- 
ulations adjusting a parent corporation's basis in the stock of a sub- 
sidiary by the earnings and profits of the subsidiary. 

At the time these regulations were issued, virtually all "defer- 
ral" items that reduced taxable income also reduced earnings and 
profits and, correspondingly, reduced the basis of the parent corpo- 
ration in the stock of a subsidiary under the regulations. For exam- 
ple, if a subsidiary generated accelerated depreciation deductions, 
that reduced the basis of its assets, such amounts reduced earnings 
and profits. Under the regulations the parent corporation's basis in 
the stock of the subsidiary is adjusted upward for accumulated 
earnings and profits and downward for deficits in earnings and 
profits. This basis thus reflected the fact that the group had received 
a reduction in tax by reason of the accelerated depreciation and the 
parent corporation's basis in the subsidiary stock thus tended to be 
adjusted in accordance with the basis of assets in the hands of the 
subsidiary. When the subsidiary was sold, there would be a corre- 
sponding increase in the amount of tax from the sale. 

In later years. Congress amended the provisions of the Code that 
define earnings and profits to change the treatment of certain de- 
ferral items so that these did not reduce earnings and profits. The 
principal purpose of these changes was to prevent corporations 
with economic profits from making tax-free distributions to individ- 
ual shareholders. This could occur if earnings and profits were re- 
duced, because a distribution is a "dividend", taxable in full to an 
individual shareholder as ordinary income, only if it is paid out of 
earnings and profits. If it is not, the shareholder recovers basis first 
and thereafter may have capital gain income. Congress first 
changed the earnings and profits treatment of accelerated deprecia- 
tion so that the full accelerated depreciation deduction did not 
reduce earnings and profits. In later years (1984), Congress made 
similar adjustments to earnings and profits for certain other defer- 
ral items, such as income reported on the installment sale basis or 
under the completed contract method of accounting. Under the 
1984 changes, such items increased earnings and profits even 
though they had not yet been included in taxable income. 

Although the changes to the definition of earnings and profits 
were intended to prevent tax-free distributions to individual share- 
holders, they also applied to corporate shareholders. A corporate 
shareholder is eligible for the dividends received deduction and 
thus, unlike an individual, may obtain a greater tax-free return if 

(166) 



167 

a distribution is a dividend than if it is not. A similar benefit may 
exist if the corporations are fiUng consoHdated returns, since inter- 
group dividends are ehminated from income under the consolidated 
return regulations. Furthermore, even if there is not distribution 
in the consolidated return case, the increased earnings and profits 
prevents the parent's basis in the subsidiary's stock from reflecting 
the subsidiary's assets basis and the tax benefit that has reduced 
that basis. 

In connection with the more recent of the changes to the definition 
of earnings and profits (in 1984), Congress recognized this potential 
and provided in the nonconsolidation case that the new rules (which 
prevented a reduction in earnings and profits for specified deferral 
items) do not apply for purposes of determining the income of a 
corporate distributee (or its basis in the distributing corporation's 
stock) if the corporate distributee owns 20 percent or more of the 
distributing corporation's stock. The legislative history to the 1984 
changes indicated an expectation that consistent rules would be 
adopted in the consolidated return area, but the consolidated return 
regulations have not to date been changed. Furthermore, a similar 
statutory rule had not been adopted with respect to the earlier 
statutory changes providing that earnings and profits are not re- 
duced by the full amount of accelerated depreciation. 

One effect of these statutory changes to the definition of earn- 
ings and profits was to change the taxation of corporations filing 
consolidated returns when a subsidiary is sold. Because earnings 
and profits of a subsidiary are not reduced by the full amount of 
accelerated depreciation, the parent corporation's basis in the stock 
of the subsidiary is not decreased to reflect the full deduction. The 
parent therefore is now able to sell the stock of the subsidiary 
without gain (even though the untaxed income is retained by the 
subsidiary) or with an artificial loss (for example, if threre has 
been a dividend distribution of any part of the tax-free income, or 
if the subsidiary's losses have sheltered other income of the 
parent). The Tax Court, holding that the present consolidated 
return regulations govern the outcome unless they are changed, 
has refused to entertain the Internal Revenue Service's position 
that the present situation creates a benefit similar to a "double de- 
duction." Woods Investment Company v. Commissioner, 85 T.C. 274 
(1985). 

A similar benefit may exist outside of the consolidated return 
context in the case of items not covered by the 1984 changes (e.g., 
accelerated depreciation). A parent corporation can withdraw as a 
dividend subsidiary earnings that have not borne tax due to the de- 
ductions. The dividend is not taxed to the parent because of the 
dividends received deduction; and does not reduce the parent's 
basis in the stock of the subsidiary. The subsidiary might then be 
sold without tax on the economic gain retained by the parent. 

Possible Proposals 

1. The parent's basis in stock of a subsidiary with which it files a 
consolidated return could be adjusted only to the extent the sub- 
sidiary's basis in its assets is adjusted (e.g., the parent's basis with 
respect to deferral items could be adjusted only to the extent of rec- 
ognized gain or loss). 



168 

2. Congress could explicitly apply the rule adopted in 1984, for 
corporations owning at least 20 percent of a subsidiary, to the earli- 
er changes to the definition of earnings and profits for other defer- 
ral items (such as accelerated depreciation) adopted prior to 1984, 
and clarify the immediate impact of the changes on corporations 
filing consolidated returns. 

Pros and Cons 
Arguments for the proposals 

1. The proposals would eliminate an unintended effect of prior 
legislation and would prevent what is in effect a double deduction. 
The proposals would thus properly measure the amount of gain or 
loss on the disposition of stock in a subsidiary. The current situa- 
tion is an anomaly in the operation of the consolidated return reg- 
ulations that was created by legislation enacted for other purposes. 

2. For corporations not filing consolidated returns, it is appropri- 
ate to provide similar earnings and profits rules for all deferral 
items, including accelerated depreciation. Congress should apply 
the statutory rules for other items to this item, to prevent attempts 
to use the dividends received deduction, outside of consolidation, to 
withdraw untaxed earnings from a subsidiary tax-free prior to sale 
without any corresponding basis reduction in the stock of the sub- 
sidiary. 

Arguments against the proposals 

1. The consolidated return regulations should be within the prov- 
ince of the Treasury Department, and a legislative solution to the 
treatment of corporations filing such returns is inappropriate. 

2. Accelerated depreciation should be treated differently from 
other deferral items where corporations are not filing consolidated 
returns. 



c. Limit consolidated return pass-through 
Present Law 

Under present law, corporations may file consolidated tax re- 
turns if they are members of an affilated group of corporations. In 
general, a parent and a subsidiary corporation are members of an 
affiliated group for this purpose if the parent corporation owns 
stock of the subsidiary possessing at least 80 percent of the total 
voting power and value of all the subsidiary stock (excluding cer- 
tain nonvoting preferred stock). 

Under the consolidated return regulations, the consolidated tax 
return of a parent corporation and an affiliated subsidiary general- 
ly allows 100 percent of a subsidiary's losses to offset the parent's 
income, or, conversely, allows 100 percent of a subsidiary's income 
to be offset by the parent's losses, even though the parent may own 
less than 100 percent of the subsidiary's stock (other than excluded 
non-voting preferred stock). However, the parent corporation gener- 
ally adjusts its basis in the subsidiary common stock downward 
only for its allocable portion of deficits in subsidiary earnings and 
profits (reflecting its share of common stock). No deficits are allo- 
cated to preferred stock and no downward basis adjustment is re- 
quired with respect to preferred stock held by the parent. Upward 
basis adjustments are made to both common and preferred stock of 
the parent, but only for the parent's allocable portion of earnings 
and profits (based on its actual stock ownership). 

Under these rules, for example, a parent corporation can own 80 
percent of the value and vote of a subsidiary corporation's stock, 
(or an even lower percentage if nonvoting preferred stock is owned 
by others) and can utilize 100 percent of the subsidiary's losses to 
offset its income. However, a downward basis adjustment is re- 
quired only for the parent's share of losses based on its actual stock 
ownership. Furthermore, no downward basis adjustment is re- 
quired with respect to the parent's preferred stock, even though a 
large part of the vote and value that the parent owns may be in 
the form of nonvoting preferred stock. The parent thus may be able 
to sell stock without gain where basis is not reduced. 

Also, a parent with losses can own less than 100 percent of a sub- 
sidiary and can shelter 100 percent of the subsidiary's income with 
its losses, even though the subsidiary's income is largely paid to 
others (for example, other shareholders owning nonvoting pre- 
ferred stock). 

Possible Proposals 

1. If the affiliated group owns less than 100 percent of the stock 
of a subsidiary, require separate return treatment of the percent- 
age of the subsidiary's income or loss attributable to the percentage 

(169) 



170 

that is not owned by the group. (For example, in the case of income 
there could be consolidated return treatment only of the portion of 
income corresponding to the current rules for determining the par- 
ent's allocable portion of earnings.) 

2. Require basis reduction with respect to preferred stock as well 
as with respect to common stock to the extent of deficits in subsidi- 
ary earnings and profits. 

3. If the affiliated group owns less than 100 percent of the stock 
of a subsidiary but consolidates 100 percent of the subsidiary loss, 
require a downward basis adjustment in the full amount of the loss 
claimed by the group. 

Pros and Cons 
Arguments for the proposals 

1. A corporation should not be able to offset its income or losses 
with income or losses of another corporation that are not economi- 
cally borne by the first corporation. 

2. A corporation that effectively controls another corporation 
may be indifferent as to what percentage of its investment is in the 
form of common rather than preferred stock. Permitting different 
basis adjustment rules for preferred stock than for common stock 
invites the tax-motivated manipulation of capital structure. 

3. If the affiliated group consolidates 100 percent of a subsidiary 
loss but owns less than all the stock, basis should be reduced to re- 
flect the loss the group has actually claimed. Otherwise, the group 
may purchase the losses of other shareholders and may inaccurate- 
ly measure gain when stock is sold. 

Arguments against the proposals 

1. It may be administratively difficult to determine what percent- 
age of income or loss is economically allocable to different classes 
of stock. 

2. Preferred stock may bear less risk of loss than common stock 
and it may therefore be inappropriate to reduce the basis of pre- 
ferred stock for deficits in earnings and profits in the same manner 
as in the case of common stock. 

3. If the affiliated group consolidates 100 percent of a subsidiary 
loss but owns less than all the stock, any basis adjustments should 
take account of any compensating payments and of any excess 
income that is consolidated. 



d. Debt financing and corporate acquisitions 
Present Law 

In general, corporate earnings distributed as dividends on equity 
are taxed at both the corporate level (when earned by the corpora- 
tion) and at the shareholder level (when distributed). By contrast, 
corporate earnings distributed in the form of interest on corporate 
debt bear no corporate level tax because interest is deductible. The 
Code thus creates a tax incentive to replace equity financing with 
debt financing to the extent this can reduce corporate taxes. 

Some corporations may seek to accomplish this result through 
their initial capital structure. In other cases, a corporation may 
substitute debt for equity in a recapitalization, or may borrow and 
distribute the proceeds of the borrowing to shareholders. The sub- 
stitution of debt for equity can also be accomplished in an acquisi- 
tion in which the company is acquired with the use of significant 
amounts of debt incurred at the corporate level (a "leveraged ac- 
quisition"). 

It is frequently difficult to distinguish debt from equity and nu- 
merous common-law factors are considered in making this distinc- 
tion under present law. These factors include whether there is a 
contract right to repayment of a specified amount at a specified 
date and whether there is a reasonable economic expectation of 
such repayment. Debt to equity ratios, degree of subordination of 
the debt, and potential for upside equity participation are consid- 
ered along with other items. 

Section 385 of the Code, enacted in 1969, gave the Treasury De- 
partment authority to write regulations distinguishing corporate 
debt from equity. Although several different sets of regulations 
have been proposed, all have been withdrawn without being adopt- 
ed. 

Section 279 of the Code denies corporate interest deductions on 
certain indebtedness incurred to acquire stock or substantially all 
the assets of another corporation. In general, that section denies a 
deduction for interest exceeding $5 million on corporate acquisition 
indebtedness if (1) the debt is subordinated to claims of trade credi- 
tors or to substantial unsecured debt, (2) the debt is directly or indi- 
rectly convertible, and (3) either the debt equity ratio exceeds 2 to 
1, or the projected earnings do not exceed 3 times the annual inter- 
est. 

Under present law, a corporation must recognize gain at the cor- 
porate level when it realizes the value of its appreciated property 
by distributing such property to its shareholders. However, a corpo- 
ration does not generally recognize gain when it realizes the value 
of its appreciated property by borrowing against the unrealized ap- 
preciation and distributing the proceeds to shareholders. This per- 
mits the removal of asset value from corporate solution through 

(171) 



172 

the substitution of debt for equity frequently without any current 
corporate level tax. 

If the assets of a corporation are purchased, the corporation rec- 
ognizes gain and the purchaser obtains a stepped-up fair market 
value basis for the assets. However, if the stock of a corporation is 
purchased, there is no corporate-level recognition of gain on the 
underlying assets, and the assets retain a carryover basis without 
any step-up to fair market value. 

Distributions of appreciated property are generally taxed at the 
corporate level. However, certain divisive distributions of appreci- 
ated corporate stock are tax-free under section 355 of the Code. 
Generally, that section requires that the stock that is distributed 
not be acquired by the distributing corporation within 5 years in a 
taxable transaction. Also, the distribution must not be a device for 
the distribution of earnings and profits. There is no specific re- 
quirement that the recipient have held the distributed company, 
directly or indirectly, for any specified period of time before or 
after the distribution. For example, a new shareholder who recent- 
ly acquired the distributing corporation in a taxable transaction 
could still receive a qualified section 355 stock distribution. Simi- 
larly, following a section 355 stock distribution, recipient share- 
holders might in some circumstances attempt to sell some or all of 
their stock if the possibly subjective standards for tax-free treat- 
ment (including the device test) are arguably satisfied. 

Possible Proposals 

1. Codify a series of rules to distinguish debt from equity, based 
on some or all of the common law standards. Require corporations 
to treat as stock those instruments that purport to be debt but that 
do not satisfy the codified rules for classification as debt. Special 
rules could be provided in the case of acquisitions or other specified 
transactions; for example, section 279 could apply to stock acquisi- 
tions if any one (rather than all three) of its conditions were met. 

2. Impose a limitation on the amount or percentage of earnings 
on future investment that can be deducted as interest. 

3. Deny deductions for interest on corporate debt to the extent 
the proceeds replace equity. This approach could be limited to cases 
in which certain other conditions are satisfied, such as a high debt 
equity ratio, a high interest rate, or other factors suggesting a sig- 
nificant risk or market concern that principal might not be repaid. 

4. Require recognition of corporate level gain to the extent corpo- 
rate level debt is incurred in excess of corporate level underlying 
asset basis. 

5. Require recognition of corporate level gain in a stock acquisi- 
tion as it is in an asset acquisition. 

6. Permit nonrecognition in a divisive distribution of corporate 
stock only if the stock distributed is directly or indirectly owned by 
the distributee shareholders for a specified period of time (e.g., 5 
years) before or after the distribution. 



173 

Pros and Cons 
Arguments for the proposals 

1. The Code should not encourage the structuring of investment 
as debt as a means of avoiding corporate level tax. Excessive lever- 
aging reduces corporate flexibility and increases the risk of insol- 
vency. 

2. Debt incurred in the context of an acquisition or redemption 
may be particularly likely to be unhealthy for the corporation. 
Though section 279 of present law applies to acquisitions, the com- 
bmation of factors required to trigger that section is readily avoid- 
able and the provision is widely regarded as ineffective. New 
owners that do not place their own capital or employment signifi- 
cantly at risk may be particularly willing to incur substantial 
amounts of debt and resell their stock taking advantage of any im- 
mediate increase in share prices, for example, due to reduction of 
corporate taxes. 

3. Corporations should not be permitted to distribute corporate 
asset value to shareholders without any current corporate level 
tax, thus removing assets from the corporate level tax base, and re- 
placing the value with debt that reduces subsequent corporate tax. 

4. Some observers argue that the acquisition of corporate stock 
and the acquisition of the underlying assets should be treated simi- 
larly for tax purposes. It is appropriate to require recognition of 
corporate level gain in a stock acquisition in the same manner as 
in an asset acquisition. 

5. The rules permitting tax-free distributions of corporate stock 
were intended to apply in cases where there was a mere readjust- 
ment of a shareholder's continuing interest in a corporation in 
modified form. This rationale is not present where the shareholder 
has recently acquired its interest in the distributing corporation 
through a taxable acquisition, or where the shareholder sells the 
distributed stock without having held it for a substantial period of 
time. 

6. The threat of acquisitions distracts corporate management 
from the most efficient management of the corporation. Acquirors 
frequently do not enhance corporate efficiency but merely resell 
pieces of the corporation in a manner that can cause disruption of 
effective management and dislocation of employees. 

Arguments against the proposals 

1. It may be difficult to create an effective mechanism for distin- 
guishing debt from equity. Many of the existing common law fac- 
tors are manipulable so that similar economic consequences can be 
characterized either as debt or as equity. "Bright-line" tests based 
on such factors might remain manipulable. To the extent they are 
not, they may unfairly disadvantage corporations that could bene- 
fit economically from borrowing. 

2. Restricting interest deductions solely in the context of an ac- 
quisition fails to account for the fact that existing management 
may seek to increase corporate level debt as an anticipatory defen- 
sive mechanism or for other purposes. A new owner with potential- 
ly more efficient management should not be precluded from obtain- 
ing the same tax benefits an old owner could obtain. 



174 

3. Restricting interest deductions solely in context of an acquisi- 
tion favors large potential purchasers, who do not need to borrow, 
over smaller, possibly more efficient purchasers. Similarly, corpo- 
rate acquisitions should not be discouraged since new owners and 
new management may be more efficient than the old owners and 
management. 

4. Corporations should not be precluded from maximizing stock 
values by incurring debt or replacing equity with debt. Corporate 
interest expense is a cost of doing business and is properly deducti- 
ble in computing taxable income. 

5. Requiring recognition of corporate level gain in the case of a 
stock purchase imposes too heavy a burden on acquisitions; more- 
over, corporate level tax will be collected at some point in the 
future since the assets in cororate solution retain a carryover basis. 

6. Divisive corporate distributions should not be subjected to a 
heavier tax burden merely because of a recent acquisition of the 
parent corporation, or a subsequent sale of the distributed stock of 
a type that would not violate present law section 355. 



% 



e. Stock redemptions 

Present Law 

If a corporation distributes earnings as a dividend, individual 
shareholders pay tax on the full amount of the distribution at ordi- 
nary income tax rates. If instead the distribution takes the form of 
a nonprorata redemption, the recipient may claim that the amount 
received is taxed as if a portion of the stock were sold; thus, the 
amount received is treated as taxable income only to the extent it 
exceeds the basis of the stock surrendered. In some circumstances, 
a taxpayer receiving a distribution may take the position that 
"sale" treatment applies even though the recipient still retains a 
significant portion of its prior stock interest in the corporation. 

Generally, a stock dividend is taxable income to a stockholder 
who had the option of receiving cash instead of stock. However, in 
the case of certain redemptions, shareholders who do not surrender 
stock but increase their interest in the corporation may not treat 
their increased stock interest as the equivalent of a taxable stock 
dividend. 

If a corporation makes a dividend distribution to its sharehold- 
ers, the shareholders are taxed on the full amount of the distribu- 
tion (unless they are corporate shareholders eligible for the divi- 
dend-received deduction). The corporation does not recognize any 
gain on appreciation in its retained assets. 

If a corporation makes a liquidating distribution to its sharehold- 
ers, all of its inside asset gain is recognized since the appreciated 
assets are distributed however, the shareholders pay tax on the 
amount distributed only to the extent it exceeds their basis in their 
stock. 

If a corporation redeems its stock in a transaction that is not 
treated as a dividend to the shareholders, the shareholders recog- 
nize gain only to the extent the amount received exceeds their 
stock basis. The corporation does not recognize gain on apprecia- 
tion in its retained assets. 

There is an exception to the general rule that a corporation rec- 
ognizes gain on a liquidating distribution, in the case of certain dis- 
tributions to a controlling corporate shareholder (an 80-percent dis- 
tributee). By contrast, a nonliquidating distribution to such a dis- 
tributee would cause the distributing corporation to recognize gain. 

Possible Proposals 

1. Treat the full amount of a distribution to an individual share- 
holder who does not terminate his or her interest as taxable 
income, whether or not some stock is surrendered in connection 
with the distribution. 

(175) 



176 

2. Some commentators have suggested treating non-pro rata re- 
demptions as if the amount of the distribution had been distributed 
as a dividend, pro rata to all shareholders, followed by sales among 
the shareholders. 

3. Require recognition of a portion of corporate level built-in gain 
in the case of any non-pro rata redemption. 

4. Treat liquidating distributions to a corporate 80-percent dis- 
tributee that are not taxed under present law in the same manner 
as nonliquidating distributions so that gain is recognized to the dis- 
tributing corporation. Such gain could be deferred in the case of a 
distribution to a parent corporation filing a consolidated return 
with the distributee, until triggered by a subsequent disposition or 
other event under the consolidated return regulations. 

Pros and Cons 
Arguments for the proposals 

1. Present law distinctions between dividends and "sales" of 
stock by shareholders to their corporations may be artificial in 
many cases. Some commentators have suggested that the increase 
in redemptions as a form of distribution may involve tax motiva- 
tions. 

2. If a corporation distributes property from the corporate tax 
base, the distribution should be taxed to the recipient in full unless 
the recipient terminates its interest in the corporation so that its 
actual net gain or loss from the investment can be computed. 

3. Shareholders who have the option of receiving cash or increas- 
ing their interest in the corporation should be treated as if they re- 
ceived a taxable stock dividend, regardless of the form of the distri- 
bution. 

Increases in value at the corporate level, which cause increases 
in value to the shareholders, should be taxed in full when realized. 
If shareholders do not pay tax on the full amount of a distribution 
because it is structured as a "sale" of their stock to the corpora- 
tion, the corporation should pay a proportionate share of the tax it 
would have paid if in fact all the shareholders had "sold" all their 
stock to the corporation in a liquidation. 

5. Liquidating distributions should not be treated more favorably 
than nonliquidating distributions under the Code. 

Arguments against the proposals 

1. Shareholders desiring cash might avoid the shareholder-level 
t£ix proposals by either surrendering all of their stock or by selling 
a portion of their stock to a third party who then surrenders it. 

2. Treating non-pro rata redemptions as dividend distributions 
followed by sales among shareholders requires unduly complex ad- 
ministrative determinations of the proper basis adjustment to the 
stock of remaining shareholders and could not be enforced without 
burdensome corporate reporting requirements. 

3. Treating non-pro rata redemptions in part as dividends to re- 
maining shareholders would tax such shareholders when they have 
not received any cash but have merely increased their stock inter- 
est. 



177 

4. Requiring a corporation to recognize gain on assets that are 
still retained in corporate solution is not appropriate, regardless of 
whether shareholders pay tax on the full amount of a distribution. 
That "inside" gain will be recognized later if appreciated assets are 
sold or distributed. 

5. A liquidating transfer within a corporate group is not an 
appropriate occasion for the recognition of gain. 



f. Tax benefit mergers 

Present Law 

Generally, the Code prohibits the direct sale of tax benefits from 
one corporation to another. For example, deductions for net operat- 
ing losses and built-in losses cannot be sold. Section 269 of the Code 
seeks to discourage mergers designed principally for tax purposes. 
In addition, sections 382 and 383 and the consolidated return rules 
generally seek to prevent new owners from using the target's tax 
benefits to reduce taxes on income exceeding a specified return on 
the value of target at the time of its acquisition. 

In a bankruptcy, a corporation may elect to be subject to a rule 
under which its loss carryforwards are reduced by 50 percent of the 
excess of the debt cancelled in the proceeding over the fair market 
value of the stock given to creditors in exchange. 

Section 338 of the Code permits a corporation that acquires the 
stock of another corporation to treat the transaction as a purchase 
of the underlying assets; however, losses of the purchasing corpora- 
tion may not be used to offset any of the built-in gain on the ac- 
quired assets. j 

Nevertheless, there are a number of acquisition techniques | 
through which taxpayers may attempt to claim the use of tax bene- j 
fits that could not otherwise be used. ! 

For example, although section 382 of the Code generally limits | 
the acquisition of losses, including built-in losses, the limitations of 
that section do not apply to built-in depreciation deductions. The 
consolidated return regulations do limit the use of an acquired cor- 
poration's built-in depreciation deductions against income of other ' 
members of the group, but not against income of the acquired cor- 
poration itself. A profitable acquiring company may, subsequent to 
the acquisition of a company with substantial built-in depreciation t 
deductions, attempt to transfer some of its income-producing assets '■ 
to the target in an attempt to avoid the consolidated return rules. ^ 

As another example, a loss corporation may acquire a profitable 
company or a company with built-in gains and seek to use its losses 
without limitation against the income or built-in gains of the 
target. To the extent the loss company can shelter the cash-flow 
from the target's assets or asset sales with its losses, it may be able ; 
to offer a better price than a competing bidder in some circum- j 
stances. 

A loss company that has no significant assets that could generate f 
income may attempt to acquire a profitable target through the use ; 
of preferred stock as a financing mechanism, with the target's own 
income or assets effectively providing the funds for the acquisition. ^ 

A loss company may also attempt to act in effect as a conduit for , 
the sale of a corporation with substantial built-in gain assets. A ^ 
loss company may acquire the stock of the other company and take 

(178) 



179 

the position that the assets can then be sold to a new buyer with- 
out corporate level tax (claiming that the gain on the sale of the 
assets is offset by its losses), while the new buyer obtains a stepped- 
up, fair market value basis. The judicially developed step-transac- 
tion doctrines of present law may not be adequate to deter such 
transactions. 

Possible Proposals 

1. Subject built-in depreciation to the built-in loss rules of section 
382 of the Code. 

2. Require the loss carryforwards of a corporation in bankruptcy 
to be reduced by the full amount of the excess of the debt cancelled 
in the proceeding over the fair market value of the stock given to 
creditors in exchange. 

3. Prevent loss corporations from using their losses to shelter any 
built-in gains of an acquired company. 

4. Prevent loss corporations from using losses to shelter gains or 
income from (a) property the purchase of which is effectively fi- 
nanced by preferred stock, or (b) property that is resold (possibly 
other than in the ordinary course of business) without having been 
held, subject to risk of loss, for a substantial period {e.g., at least 5 
years). 

Pros and Cons 
Arguments for the proposals 

1. Built-in depreciation deductions should be treated the same as 
other built-in losses and should be subject to the limitations that 
apply under section 382 when more than 50 percent of the stock of 
a loss corporation is acquired. 

2. Cancellation of creditors' claims should be treated as a benefit 
reducing prior losses, in the case of a bankrupt corporation just as 
it would be for other corporations. 

3. Loss corporations should not have a competitive advantage 
over other corporations seeking to acquire businesses and should 
not be able to act as indirect conduits for the sale of businesses. 

Arguments against the proposals 

1. Subjecting built-in depreciation to the loss limitations of sec- 
tion 382 would be administratively complex. Although the existing 
consolidated return regulations may theoretically involve similar 
complexity, they may not as a practical matter have come into play 
in many cases. 

2. Corporations in bankruptcy should not be subject to any great- 
er restrictions on the future use of losses than under present law, 
since the use of such losses may assist their future recovery. 

3. Loss corporations should not be restricted in obtaining the 
benefit of their losses against any other income, or in marketing 
their losses to shelter gains or income, including income that may 
accrue to the economic benefit of another party. 



g. Limit sales of losses using preferred stock 
Present Law 

A corporation with net operating losses may not sell those losses 
directly and, if more than 50 percent of its stock (not counting cer- 
tain nonvoting preferred stock) is acquired, its use of losses in the 
hands of the new shareholders is limited under section 382, as 
amended by the Tax Reform Act of 1986. Furthermore, the legisla- 
tive history of the Act indicates that a loss corporation may not 
transfer its losses indirectly by participating as a partner in a part- 
nership in which it effectively sells its losses to other partners. 

However, a loss corporation or its consolidated subsidiary may 
attempt in effect to sell its losses by issuing new nonvoting pre- 
ferred stock to corporate shareholders that are eligible for the divi- 
dends received deduction. So long as the issuing corporation has 
sufficient earnings and profits to cover the dividends, the recipient 
coporate shareholder pays tax on the dividends at a maximum rate 
of 6.8 percent, due to the dividends received deduction. At the same 
time, the payor corporation may be paying no tax on the earnings 
distributed, because the loss carryovers of the loss company shelter 
taxable income (earnings and profits for dividend purposes can 
exist without taxable income). 

A loss company can thus sell its losses, for example, by issuing 
preferred stock to corporate shareholders at a favorable dividend 
rate that essentially compensates the issuing corporation for the 
use of its losses to shelter the income that supports the dividend 
payments. 

Because nonvoting preferred stock generally is not counted for 
purposes of determining whether more than 50 percent of a corpo- 
ration's stock has been acquired under section 382, a loss corpora- 
tion can effectively transfer an unlimited amount of its earnings to 
nonvoting preferred shareholders for new capital against which its 
losses are used. 

Such transactions are also facilitated because nonvoting pre- 
ferred stock does not generally count for purposes of determining 
whether a parent corporation owns 80 percent of the stock of a sub- 
sidiary. Thus, the two companies may be able to file consolidated 
returns even though a large part of the value of the subsidiary is 
accounted for by preferred stock not owned by the parent. Some 
loss corporations thus have created subsidiaries that receive a sub- 
stantial amount of new capital in the form of nonvoting preferred 
stock issued to investors who might be reluctant to invest directly 
in the parent loss corporation. The taxpayers assert that the earn- 
ings on the subsidiary's assets, which provide dividends to the in- 
vestors, can be sheltered by the parent's losses on a consolidated 
return. Moreover, present law rules permit but do not require the 
subsidiary's earnings and profits to be reduced by the amount of 

(180) 



181 

taxes it would owe but for the use of the parent's losses. Thus, 
earnings and profits are available in the subsidiary to support "div- 
idend" treatment of distributions on the preferred stock. 

Possible Proposals 

1. Deny the use of loss carryovers to offset income used to pay 
dividends on certain preferred stock — for example, stock that is 
issued to outside investors and that is not counted for purposes of 
determining whether there has been an ownership change or that 
is not counted for purposes of determining whether the corpora- 
tions may file consolidated returns. 

2. Require nonvoting preferred stock to be counted for purposes 
of determining whether more than 50 percent of the value of the 
company has been acquired if this would trigger the loss limita- 
tions of section 382 of the Code. 

3. If a loss corporation is affiliated with another corporation that 
issues nonvoting preferred stock, do not permit consolidation of 
the losses unless the nonvoting preferred stock is counted for 
consolidation purposes {e.g., if the loss company is the parent, it 
must own 80 percent of the nonvoting preferred stock of the subsid- 
iary). Alternatively, either require separate return treatment of 
the income used to pay dividends on the nonvoting preferred stock 
or reduce the earnings and profits of the profitable company by an 
amount equal to the taxes it would have owed without the affili- 
ate's losses. 

Pros and Cons 

Argument for the proposals 

Corporations with loss carryovers should not be able to sell those 
losses without limitation to new investors through the use of non- 
voting preferred stock. To the extent the net operating loss limita- 
tions are intended to prevent new owners from using prior corpo- 
rate losses to offset a return on the new investor's new capital, the 
rules are not fully effective under the present law approach to non- 
voting preferred stock. Furthermore, the tax system should not 
provide a double benefit to new investors by permitting both the 
use of a prior net operating loss and the dividends received deduc- 
tion. 

Argument against the proposals 

The existing transferability of losses through the use of preferred 
stock assists loss corporations in raising capital. Loss companies 
should not be disadvantaged if they issue preferred stock rather 
than debt. 



h. Limitations on net operating loss carryforwards of cor- 
poration following worthless securities deduction by 
shareholders 

Present Law 

A deduction is allowed for any loss sustained during the taxable 
year as a result of securities held by the taxpayer becoming worth- 
less. It has been held that, notwithstanding the fact that a worth- 
less stock deduction has been claimed by parent corporation with 
respect to stock of a nonconsolidated subsidiary, the net operating 
loss carryforwards of the subsidiary survive and may be used to 
offset future income of the subsidiary. Textron, Inc. v. United 
States, 561 F.2d 1023 (1st Cir. 1977). In Textron, the parent provided 
a portion of the funds used by the subsidiary to acquire the busi- 
ness responsible for generating this income. Use of a subsidiary's 
losses following a worthless securities deduction has been denied to 
the parent corporation, however, where its nonconsolidated subsidi- 
ary was subsequently liquidated into the parent in a section 332 
liquidation. Manuals Steel Co. v. Commissioner, 354 F.2d 997 (9th 
Cir. 1965), affg 38 T.C. 633 (1962). The court in Marwais Steel rea- 
soned that to allow the parent to use the subsidiary's losses would 
permit it to claim two deductions for a single economic loss. 

Loss carryforwards of a corporation are limited if there is a 
more-than-50-percent change in the ownership of its stock during 
the relevant testing period. The amount of losses that may be used 
annually to offset post-change income of the corporation is equal to 
a prescribed rate of return on the net value of the corporation at 
the time of the change of ownership. 

Possible Proposals 

1. Provide a rule that, if a worthless securities deduction is 
claimed by persons holding a specified percentage of a corpora- 
tion's stock, its net operating loss carryforwards and other tax at- 
tributes are extinguished. This could be accomplished, for example, 
by treating the corporation's stock as having been sold to an unre- 
lated party for purposes of the rules limiting the use of losses fol- 
lowing an ownership change. Thus, if worthless stock deductions 
were claimed with respect to more than 50-percent of a corpora- 
tion's stock during the testing period, net operating loss carryovers 
of the corporation arising prior to the change generally could not 
be used to offset the corporation's post-change income. 

2. Alternatively, provide that a subsidiary's tax attributes are ex- 
tinguished if a worthless securities deduction is claimed by an 80- 
percent-or-more parent corporation (whether or not the subsidiary 
files a consolidated return with the parent). 

(182) 



183 

Pros and Cons 
Arguments for the proposals 

1. The premise for the worthless securities deduction is that the 
shareholder's loss has been realized to the same extent as if there 
had been an actual disposition, even though the shareholder still 
technically owns the stock. Consistent with this premise, use of the 
attributes of the issuing corporation should be limited to the same 
extent as if an actual disposition had occurred. 

2. Present law in effect allows the same economic loss to be de- 
ducted twice, since the net operating losses of a corporation are 
also reflected in the loss inherent in its stock. 

3. Present law elevates form over substance to the extent it ex- 
tinguishes the subsidiary's tax attributes if the subsidiary is liqui- 
dated into the parent following the worthless stock deduction, but 
not if the separate status of the subsidiary is formally preserved, 
even if the subsidiary's post-worthlessness income is generated by 
assets provided by the parent. These situations are economically 
identical, and the tax treatment should be the same. 

4. Since no duplication of losses generally occurs in a consolidat- 
ed return context, such duplication should not be allowed to occur 
in the case of similarly situated corporations not filing a consolidat- 
ed return. 

Arguments against the proposals 

l.To the extent there is a double deduction of what is essentially 
the same economic loss, this is merely a function of the two-tier 
system of taxing corporate operations, under which corporate-level 
gains as well as losses are duplicated at the shareholder level. 

2. Application of the rules limiting loss carryforwards following a 
change of ownership is inappropriate in these circumstances. There 
has been no change in the beneficial ownership of the stock, and 
hence no transfer of the benefit of the corporation's losses. 

3. The separate status of a subsidiary corporation should be re- 
spected for tax purposes, even where it is 80-percent or more con- 
trolled. 



74-267 0-87-7 



i. Deemed dividends to corporate shareholders 
Present Law 

If persons who directly or indirectly control each of two corpora- 
tions sell the stock of one to the other, the transaction is not treat- 
ed as a sale but can be recharacterized as a dividend. However, the 
results are not exactly the same as if there had been an actual divi- 
dend distribution. Instead, there are various "deemed" conse- 
quences. The dividend is deemed to come first from the earnings 
and profits of the purchasing corporation and then from the earn- 
ings and profits of the corporation whose stock is sold. The stock 
purchased, in the hands of the acquiring corporation, has a basis 
equal to its basis in the hands of the selling person and is deemed 
to have been received as a capital contribution. Specified attribu- 
tion rules apply for purposes of determining whether a person di- 
rectly or indirectly controls the two corporations. Under these 
rules as interpreted in IRS revenue rulings, two corporations that 
are under common control can be deemed to control one another in 
some circumstances, even though one may own no stock in the 
other. 

Although the special rules were enacted to prevent individual 
shareholders (who are not eligible for the dividends received deduc- 
tion) from "bailing out" earnings from a controlled corporation at 
capital gains rates, rather than as ordinary dividend income, by 
usmg the form of a sale of stock, the rules apply not only to indi- 
vidual shareholders but also to corporate shareholders. Corpora- 
tions may prefer dividend treatment to sale treatment because the 
dividends received deduction results in a maximum tax rate of 6.8 
percent on dividends received from another corporation. Also, in 
many cases involving common control, there is no tax because the 
dividend is either eligible for the 100-percent dividends received de- 
duction applicable within an affiliated group or is excluded from 
income under the consolidated return regulations. 

The special rules can provide significant tax planning opportuni- 
ties to corporate shareholders. Not only can such shareholders re- 
ceive dividend treatment if that is more preferential than sale 
treatment; the results may also be significantly more favorable 
than if an actual dividend had been paid, due to the "deemed" 
flows of earnings and profits. Under the consolidated return regula- 
tions, for example, an increase in the earnings and profits of a sub- 
sidiary can create a corresponding increase in the parent's basis in 
the stock of the subsidiary. Although a distribution of earnings and 
profits generally reduces the parent's basis in subsidiary stock, this 
does not occur if the distribution is not made to a corporation that 
actually owns stock in the distributing company. A "deemed" sec- 
tion 304 dividend from a brother to a sister company can thus have 
the effect of increasing the basis of the stock of the company that is 

(184) 



185 

treated as "receiving" the dividend, without reducing the basis of 
the stock of any other company. 

Although since 1984 the Code has taxed a distributing corpora- 
tion on appreciation in stock it distributes to a controlling corpo- 
rate shareholder unless the distribution qualifies under the special 
conditions of section 355, taxpayers have manipulated the rules to 
claim a tax-free distribution of nonqualifying stock. Also, taxpayers 
have claimed that the distributing corporation can then be sold 
without any reduction in its basis for any portion of the assets that 
were in effect withdrawn tax-free. 

Possible Proposals 

1. Modify the rules with respect to corporate shareholders so that 
the results are not better than if the corporations had made actual 
distributions. For example, if stock is sold by a brother to a sister 
corporation, require the stock transfer to the treated as if the stock 
had actually been distributed to the common parent and recontri- 
buted to the recipient. 

2. Modify the rules of section 304 so that corporate shareholders 
in control of two corporations who purport to "sell" the stock of 
one to the other must at least experience a basis reduction in the 
stock of any subsidiary from which amounts are directly or indi- 
rectly withdrawn. Also, require transfers or deemed transfers that 
are essentially "circular" to be disregarded where appropriate to 
prevent tax avoidance, including transfers of cash to a subsidiary 
that is then sold (or that transfers cash to an affiliate that is sold) 
for a price that repays the cash amount to the seller. 

Argument for the proposals 

Corporations should not be permitted to use a provision that was 
directed at "bail-outs" by individual shareholders to obtain better 
tax results than they could have obtained by either an actual sale 
or an actual distribution. 

Argument against the proposals 

The present-law rules with respect to intercorporate distributions 
of subsidiary stock are too harsh, and it is appropriate for taxpay- 
ers to be able to use section 304 to obtain more favorable results. 



j. Afniiation rules for Alaska Native Corporations 
Present Law 

Under present law, Native Corporations established under the 
Alaska Native Claims Settlement Act (43 U.S.C. 1601 et seq.) (and 
100-percent subsidiaries of such corporations) are entitled to file 
consolidated returns if they qualify under the more liberal affili- 
ation rules formerly in effect for all corporations before the Deficit 
Reduction Act of 1984. These affiliation rules are in effect for such 
corporations for taxable years beginning before 1992. 

During the transitional period, eligibility of such corporations for 
affiliation may be determined solely on the basis of a literal appli- 
cation of the statutory requirements. No provision of the Code or 
principle of law may be applied to deny the benefit of any losses or 
credits of such corporations to the affiliated group of which the cor- 
poration is a member. Accordingly, the benefit of such losses and 
credits may not be denied, for example, by application of the as- 
signment of income doctrine, section 269 (relating to disallowance 
of deductions or credits following a tax-avoidance motivated acqui- 
sition), or section 482 (relating to the Commissioner's authority to 
reallocate income, deductions, or credits among commonly con- 
trolled businesses). 

Possible Proposals 

1. Limit utilization of losses of Alaska Native Corporations to loss 
carryforwards existing on the date of enactment of the 1986 Act, 
plus certain post-enactment losses (e.g., those incurred in taxable 
years beginning before January 1, 1988). 

2. Deny carrybacks of Native Corporation losses to 1986 or 1987 
to the extent such losses would offset income generated by a corpo- 
ration that would not be eligible for affiliation in the absence of 
the special affiliation rules. 

3. Prohibit losses from being used against income that is assigned 
to a Native Corporation subsidiary, as opposed to income that is at- 
tributable to assets of or services performed by the subsidiary. 

Pros and Cons 
Arguments for the proposals 

1. Present law permits the unrestricted sale of future losses, as 
well as losses existing at the effective date of the 1986 Act, by 
Alaska Native Corporations. This provides an undue benefit from 
the continued creation of losses. 

2. Absent a prohibition against carrybacks of future Native Cor- 
poration losses to 1986 and 1987, taxpaying corporations can assign 
income to the Native Corporation group in those years, when losses 
are worth between 40 and 46 cents on the dollar, rather than in 

(186) 



187 

the year the losses are incurred when they will be worth only 34 
cents on the dollar. 

Arguments against the proposals 

1. The special affiliation rules, including the rules allowing as- 
signment of income, assure the ability of the Native Corporations 
to derive the full benefit of their losses at the earliest possible date, 
generating funds to help the Corporations become self-sufficient. 

Revenue Effect 

[Fiscal years, billions of dollars] 
Proposal 1988 1989 1990 1988-90 

Limitations on use of losses of 
Native Corporations (i) (i) {^) 0.1 

^ Gain of less than $50 million. 



k. Denial of graduated rates for personal service corpora- 
tions 

Present Law 

Under present law, beginning July 1, 1987, corporations are gen- 
erally subject to a tax at the rate of 34 percent. However, for corpo- 
rations with a taxable income below $335,000, graduated rates are 
provided. These rates are 15 percent on taxable income not over 
$50,000, and 25 percent on taxable income over $50,000 and not 
over $75,000, with the benefits of these lower rates phased out as 
taxable income increases from $100,000 to $335,000. 

Possible Proposal 

The benefits of the graduated corporate rates could be denied to 
personal service corporations. 

Pros and Cons 
Argument for the proposal 

1. Income from personal services should not receive the benefit of 
the lower graduated corporate tax rates. Since personal service 
income may generally be paid as deductible salary to the owner- 
employees and thereby be taxed once at the owner-employees' tax 
rate, it is inappropriate to tax it at a lower corporate rate. Other 
Code provisions treat personal service corporations the same as 
their owners — e.g., the passive loss rules and the cash accounting 
provisions. 

Argument against the proposal 

1. All corporate income should be taxed at the regular corporate 
rates. The graduated rates were enacted to benefit corporations 
with lower incomes and should not be limited. 

Revenue Effect 

[Fiscal years, billions of dollars] 

\ 

Proposal 1988 1989 1990 1988-90 

] 

Eliminate graduated rates for \ 

personal service corporations.... 0.1 0.1 0.1 0.3 ] 



(188) 



1. Conversion of C corporation to S status 
Present Law 

In general, gain realized when a C corporation liquidates is sub- 
ject to corporate level tax. If a C corporation elects to convert to S 
corporation status and holds assets with a net unrealized "built-in 
gain" (that is, with a value in excess of basis) at the time of its 
conversion, the built-in gain is subject to a separate corporate-level 
tax to the extent it is realized within ten years after the conversion. 
Although built-in corporate level gain is thus generally taxed as 
realized over the 10-year period, such gain is not taxed at the 
corporate level to the extent it is offset by post-conversion losses. 

The Internal Revenue Service has stated that the inventory 
method used by a taxpayer for tax purposes shall be used in deter- 
mining whether goods disposed of following a conversion to S cor- 
poration status were held by the corporation at the time of conver- 
sion. Thus, a C corporation using the last-in, flrst-out (LIFO) 
method of accounting for its inventory which converts to S corpora- 
tion status will not be taxed on the built-in gain attributable to 
LIFO inventory to the extent it does not invade LIFO layers during 
the ten-year period following the conversion. 

Possible Proposals 

A C corporation using the LIFO method which elects S corpora- 
tion status could be required to include in income the LIFO recap- 
ture amount (that is, the excess of the inventory's value using a 
first-in, flrst-out (FIFO) flow assumption over its LIFO value on 
the date of the conversion) upon conversion. Full recapture could 
be required in the year of conversion or applying a FIFO inventory 
flow assumption, or the income could be spread over some period of 
time (e.g., five years, ten years). The built-in gain provisions could 
generally be revised to operate more effectively to measure and tax 
over a deferred period the corporate level gain existing at the time 
of conversion. 

Pros and Cons 
Arguments for the proposals 

1. The provision that imposes a separate corporate-level tax on 
built-in gains may be ineffective in the case of LIFO inventory, 
since a taxpayer experiencing constant growth may never be re- 
quired to invade LIFO inventory layers. The LIFO method C corpo- 
ration thus may, by converting to S status, escape the recapture 
tax that would have been imposed had there been a liquidation. 

2. Under present law, LIFO taxpayers electing S corporation 
status pay less corporate level tax than FIFO taxpayers, since 

(189) 



190 

LIFO recapture tax that is not paid within the 10 year period is 
never recovered. 

3. The provision dealing with conversion from C to S status 
should conform more closely to the results that would have oc- 
curred in a liquidation. 

Arguments against the proposal 

1. Built-in gain attributable to LIFO inventory is no different 
than built-in gain attributable to other types of assets, and should 
not be subject to harsher rules. Accordingly, if such inventory is 
not deemed to have been disposed of during the statutory recogni- 
tion period, no separate corporate-level tax should be imposed. 

2. The proposal would dilute the benefit of the LIFO method, the I 
use of which Congress has expressly authorized. If Congress believes ^ 
that the LIFO method provides unwarranted tax benefits, it should e 
address this problem directly, not by triggering recapture upon a | 
conversion to S status which is not treated as a liquidation for other \ 
purposes. 

3. It is inappropriate to more closely conform the results of a con- ^ 
version from C to S status to the results that would have occurred < 
if the corporation had liquidated; this imposes too heavy a burden ' 
on a conversion from C to S status. 



n 



10. Partnership Provisions 

a. Master Limited Partnerships (MLPs) 
Present Law 

Under present law, a partnership is not subject to tax at the 
partnership level, but rather, income and loss of the partnership is 
subject to tax at the partner's level. A partner's share of partner- 
ship income is generally determined without regard to whether he 
receives any corresponding cash distributions. Similarly, partner- 
ship deductions, losses and credits are taken into account at the 
partner level for tax purposes. 

The amount of losses that a partner may deduct for a particular 
year may not exceed the amount of the adjusted basis of his part- 
nership interest (sec. 704(d)), nor may such deductions exceed the 
partner's amount at risk for the year (sec. 465) in the case of indi- 
vidual and certain closely held corporate partners. The passive loss 
rule (which, except as provided in regulations, treats a limited 
partnership interest in an activity as an interest in a passive activ- 
ity) generally limits deductions from passive activities to the 
income from all passive activities (or in the case of credits, to the 
tax liability attributable to passive activities). These rules general- 
ly do not limit the use of losses, deductions and credits from a lim- 
ited partnership's activity to shelter income earned in the limited 
partnership's activity. Thus, unlike corporate dividend distribu- 
tions which generally are taxed to the corporate shareholders (re- 
gardless of whether income tax was paid at the corporate level), 
distributions of partnership cash flow can be made to partners on a 
largely or completely tax-free basis. 

Treasury regulations distinguishing partnerships from corpora- 
tions currently provide that whether a business entity is taxed as a 
corporation depends on which form of enterprise the entity "more 
nearly" resembles (Treas. Reg. sec. 301.7701-2(a)). The regulations 
list six corporate characteristics, two of which are common to cor- 
porations and partnerships, and the other four of which are: (1) 
continuity of life, (2) centralization of management, (3) liability for 
corporate debts limited to corporate property, and (4) free transfer- 
ability of interests. The regulations provide that an association is 
treated as a corporation (rather than a partnership) for Federal 
income tax purposes if it has more corporate than non-corporate 
characteristics. Under these regulations, large publicly traded lim- 
ited partnerships can technically be treated as partnerships rather 
than corporations, despite the expectation that the partnerships 
are likely to continue in existence and the fact that the partner- 
ships' limited partners have limited liability, can transfer their in- 
terests, and do not participate in management. 

(191) 



192 

Possible Proposals 

1. Publicly traded limited partnerships could be treated as corpo- 
rations for Federal income tax purposes, with a grandfather rule 
for existing partnership capital. The Administration has expressed 
support for this proposal. Alternatively, the same treatment could i; 
be applied to publicly offered limited partnerships, i.e., those in 
which interests are offered for sale in a transaction required to be ' 
registered with a Federal or State securities regulatory agency. 

2. Withholding (or collection of partners' estimated tax liability) j 
could be imposed at the partnership level on partners' shares of 
income from publicly traded or publicly offered limited partner- o 
ships. 1 

3. Publicly traded or publicly offered limited partnerships (or all i 
limited partnerships) could be treated as corporations or non-pass- 
through entities under the alternative minimum tax, or holders of j 
interests in such entities could be treated as subject to the book \ 
income and adjusted current earnings provisions of the corporate 
alternative minimum tax. 

4. Publicly traded or publicly offered limited partnerships could 
be treated as entities that do not pass through tax losses, deduc- 
tions or credits to limited partnerships, and net income of the part- 
nership could be treated as portfolio (rather than passive) income 
to the partners under the passive loss rule. 

Pros and Cons 
Arguments for the proposals 

1. Publicly traded limited partnerships resemble publicly traded 
corporations in their business functions and in the way their inter- 
ests are marketed, and limited partners resemble corporate share- 
holders in that they have limited liability, may freely transfer 
their interests, generally do not participate in management, and 
expect continuity of life of the entity for a term necessary to its 
purposes. Consequently, these types of entities and their holders 
should be treated similarly for Federal income tax purposes. 

2. The availability of passthrough treatment in the form of pub- 
licly held interests encourages tax-motivated decisions as to choice 
of business form, rather than tax-neutral, economically motivated 
decisions. 

3. The availability of elective integration of the corporate and 
shareholder level tax through the use of publicly held limited part- 
nerships in lieu of corporations is contrary to the express policy de- 
termination of Congress to maintain distinct corporate and individ- 
ual income taxes, and erodes the corporate tax base. 

4. The availability of passthrough treatment in the form of pub- 
licly held limited partnership interests creates an unintended com- 
petitive advantage for certain businesses or industries that are 
most readily able to conduct business in the form of limited part- 
nerships. 

5. Unlike small general partnerships, large or publicly traded 
limited partnerships are not, in a realistic economic sense, the 
alter egos of the partners and thus there is little justification for 
maintaining conduit tax treatment for them. 



193 

6. The partnership rules were not designed for publicly traded 
partnerships; such partnerships may have difficulty complying 
with the partnership rules, and create audit difficulties stemming 
from complex, difficult-to-monitor calculations that are applied to 
hundreds of partners, and place an excessive burden on the admin- 
istration and collection mechanisms of the tax law. 

Arguments against the proposals 

1. Under currently authorized Treasury regulations (in effect for 
over 25 years) that distinguish between partnerships and other en- 
tities, as they have been interpreted, the corporate characteristics 
of publicly traded limited partnerships are generally insufficient to 
merit routine recharacterization of such partnerships as corpora- 
tions for Federal income tax purposes. 

2. The current system of two levels of tax on corporate income is 
irrational, and the opportunity to integrate the two levels of tax 
electively through the use of publicly held limited partnerships 
should be preserved. 

3. The formation of publicly traded limited partnerships by cor- 
porations with temporarily highly leveraged assets (e.g., following a 
leveraged buyout) offers such corporations an opportunity to clear 
the debt off the corporate books faster by substituting partnership 
equity for the debt, thus increasing the corporation's stock price to 
reflect its true net worth. 

4. Treating general categories of large limited partnerships as 
corporations, or as non-passthrough entities, may be unfair in cer- 
tain instances where the owners of a particular partnership are 
indeed personally engaged in the partnership's activities and the 
partnership is substantially their economic alter ego. Further, part- 
ners of large partnerships may not be less involved in partnership 
activities than partners of some smaller partnerships. 

5. Publicly traded limited partnerships may have a business utili- 
ty in only a limited number of contexts, and thus do not represent 
a significant potential for erosion of the corporate tax base, or a 
significant contradiction of express Congressional policy to main- 
tain separate corporate and individual tax regimes. 

6. Treating certain partnerships differently for regular and for 
alternative minimum tax purposes could give rise to undue com- 
plexity in the administration of the tax law. 



b. Partnership allocations 

Present Law 

Present law provides that a partnership is not subject to income 
tax, but rather that the partners are separately subject to tax on 
their distributive shares of the partnership's overall income or loss 
(and the partnership's separately computed items of income, gain, 
loss, deduction or credit). In general, if the partnership agreement 
does not provide as to the partner's distributive share, then his dis- 
tributive share is determined in accordance with the partner's in- 
terest in the partnership (determined by taking into account all 
facts and circumstances). Partnership income, gain, loss, deduction 
or credit (or items thereof) may be allocated under the partnership 
agreement, but if the allocation does not have substantial economic 
effect, then the partner's share is redetermined in accordance with 
his interest in the partnership. 

Treasury regulations describing when an allocation has substan- 
tial economic effect provide generally that to have economic effect, 
an allocation must be consistent with the underlying economic ar- 
rangement of the partners, and for the economic effect to be sub- 
stantial, there must be a reasonable possibility that the allocation 
will affect the dollar amounts received by the partners, independ- 
ent of tax consequences. More detailed requirements also apply. Al- 
location of deductions attributable to nonrecourse debt, for which 
no partner is personally liable, is permitted (provided that the part- 
nership agreement provides for a chargeback to the partner of the 
minimum gain attributable to the nonrecourse debt), even though 
such allocations cannot have economic effect. 

The regulations permit allocations that shift over time (e.g., 
where items are initially allocated to one partner or group of part- 
ners, and subsequently are allocated to others). Similarly, items of 
partnership income may be allocated to a tax-exempt partner (or a 
partner with a low effective tax rate) at the same time that the 
corresponding cash flow is distributed to other partners. 

Under present law, tax-exempt organizations generally are sub- 
ject to tax on unrelated business income. In general, income from 
debt-financed property is treated as unrelated business income. An 
exception from the unrelated business income tax is provided, in 
the case of debt-financed real property, provided the property is not 
leased back to the seller and certain other requirements are met, 
even if, at the same time, income can be allocated to tax-exempt 
partners and losses to taxable partners. 

The rules relating to partnership allocations do not apply to 
amounts paid with respect to partnership debt. Thus, although 
partnership income may be paid out in the form of debt service, 
such payments are not treated as allocations of income under the 

(194) 



195 

partnership agreement. Similarly, fees paid to partners for services 
are not generally treated as allocations of partnership income. 

Possible Proposals 

1. Where a partnership has both taxable and tax-exempt part- 
ners, the income allocated to the taxable partners could be re- 
quired not to be less (nor the losses and other tax benefits greater) 
than the amount allocable in accordance with the taxable partner's 
interest in the partnership. 

2. Arrangements whereby allocations to particular groups of 
partners change over time (e.g., where initial losses are allocated 
principally to taxable partners, and later income is allocated to 
other partners) could be treated as not having substantial economic 
effect nor being in accord with partners' economic interests in the 
partnership. 

3. Payments on partnership debt held by tax-exempt organiza- 
tions, and payments to such organizations for services, could be 
taken into account in determining whether partnership allocations 
have substantial economic effect. Alternatively, these types of pay- 
ments could be taken into account regardless of the identity of the 
payee in determining the substantial economic effect of partner- 
ship allocations. 

4. Where allocations in the partnership agreement result in allo- 
cation of more than a particular percentage (e.g., 35 percent) of 
partnership losses to taxable partners, and the partnership in- 
cludes both taxable and tax-exempt (or low effective rate) partners, 
then allocations that are consistently the same for all items could 
be required. 

Pros and Cons 
Arguments for the proposals 

1. The large degree of flexibility in partnership allocations under 
present law is excessive because it allows what is in effect the sale 
of tax benefits. This directly contravenes policy expressed by Con- 
gress in, for example, the repeal of safe harbor leasing in 1982. 

2. Allowing partnership allocations that are actually sales of tax 
benefits causes economically inefficient investment decisions moti- 
vated by tax rather than economic factors, and harms the economy. 

3. Allowing partnership allocations that are actually sales of tax 
benefits is unfair, because it permits those who can invest in part- 
nerships to receive tax-free distributions of partnership cash flow,^ 
while other taxpayers must generally pay tax on cash they receive. 

Arguments against the proposals 

1. The partnership rules are designed to provide significant flexi- 
bility for partners to arrange their affairs, and rules limiting allo- 
cations are contrary to this purpose. 

2. Limitations on partnership allocations that do not have sub- 
stantial economic effect and that may represent mere transfers of 
tax benefits are already imposed in the Treasury regulations imple- 
menting sec. 704(b), and further limitations would be redundant 
and would add unnecessary complexity to an already complex area. 



c. Transactions between partners and partnerships 
Present Law 

Present law provides that, in general, no gain or loss is recog- 
nized by a partnership or its partners when property is contributed 
to the partnership in exchange for a partnership interest. Gain or 
loss generally is recognized, by contrast, when property is sold. In 
cases where there is a transfer of money or other property by a 
partner to a partnership, and a transfer of property or money by 
the partnership to a partner that, when viewed together, are prop- 
erly characterized as a sale or exchange, then the transfers are 
generally treated as such, and the transferor of the property is 
treated as recognizing gain (or loss, if any). 

It is not completely clear whether present law treats certain 
types of transactions as nontaxable contributions to a partnership, 
or as a sale or exchange between the contributor and the partner- 
ship. For example, when a person contributes appreciated property, 
subject to debt, to a partnership in exchange for a partnership in- 
terest, and the partnership then uses the proceeds of sales of other 
partnership interests to pay off the debt encumbering the appreci- 
ated property, it is not completely clear that the transaction is 
equivalent to a transfer of money or other property to the contrib- 
uting partner. 

Possible Proposal 

Where encumbered property is contributed to a partnership and 
proceeds of sales of partnership interests are used to pay the debt 
encumbering the property, the person who contributed the proper- 
ty could be treated as receiving a transfer of money or other prop- 
erty from the partnership in a taxable sale or exchange. 

Pros and Cons 
Arguments for the proposal 

1. A person such as a corporation that improves its economic po- 
sition by exchanging debt-encumbered property for an interest in a 
partnership that promptly pays off the debt with funds contributed 
by new partners, should be treated for tax purposes as it is treated 
for financial and economic purposes: as having gained in the trans- 
action. 

2. The proposal would treat similarly transactions that are essen- 
tially equivalent to each other in substance and differ only in form. 

Arguments against the proposal 

1. It is inappropriate to raise a tax law obstacle to having taxpay- 
ers such as corporations remove liabilities from their books so that 

(196) 



197 

stock prices reflect more accurately the true value of the corpora- 
tion's business. 

2. Making contributions of property to partnerships less attrac- 
tive from a tax standpoint, e.g., in the case of corporate contribu- 
tors, takes away one of the means of fending off hostile corporate 
takeovers, and merely perpetuates the recent wave of takeovers 
(which has been criticized as not contributing to healthy growth of 
the economy). 



d. Partnership-level income computation 
Present Law 

Under present law, a partnership is not subject to tax at the 
partnership level, but rather, each partner's share of separately 
calculated items and of overall income and loss of the partnership 
is subject to tax at the partner's level. The partnership agreement 
may provide for special allocations of items of income, gain, loss, 
deduction or credit to particular partners, provided the allocation 
satisfies standards (set forth in Treasury regulations) requiring 
that special allocations have substantial economic effect. A part- 
nership can thus pass through net income or losses to its partners, 
or can pass through deductions or other tax benefits to particular 
partners, and taxable income to other partners. A partner's share 
of partnership income is generally determined without regard to 
whether he receives any corresponding cash distributions. 

Present law provides several limitations on the deductibility of 
losses and on other tax benefits passed through partnerships (e.g., 
the passive loss rule, the at-risk rule, and partnership tax rules 
limiting partners' losses to their basis in their partnership inter- 
ests). Under the passive loss rule, activities of limited partnerships 
are treated as passive activities; except as provided in regulations 
(which have not been issued), income or loss passed through from 
limited partnerships is treated as passive. Income from limited 
partnership activities can consequently be treated as passive and 
can offset losses that would otherwise be deferred until disposition, 
under the passive loss rule. Such income-producing limited partner- 
ships have been referred to and publicly marketed as so-called pas- 
sive income generators. 

Possible Proposal 

Limited partnerships could be treated as entities that do not pass 
through tax losses, deductions or credits to limited partners. Net 
income of the entity would be subject to only one level of tax (at 
the partner level). Income of the entity would be treated as portfo- 
lio (rather than passive) income under the passive loss rule in the 
hands of the owners of the entity. Alternatively, this proposal 
could be applied to a narrower class of partnerships (e.g., publicly 
offered or publicly traded limited partnerships). 

Pros and Cons 
Arguments for the proposal 

1. Limited partnerships that pass through net income can be 
used to avoid the passive loss limitations, which the Congress just 
adopted to stop tax shelters and regain public confidence in the 
fairness of the tax system. 

(198) 



199 

2, Treating publicly offered limited partnerships as subject to one 
level of tax on distributed net income creates a more level playing 
field in comparison to other business entities not taxed as corpora- 
tions. 

3. The proposal would prevent erosion of the corporate tax base 
and solve some of the issues relating to master limited partner- 
ships by making it more likely that at least one level of tax is col- 
lected on the income of all types of business entities. 

Arguments against the proposal 

1. Owners of interests in such entities could still receive tax-free 
cash distributions, where the entity operates at a tax loss and has 
no net income that would be taxable to owners. 

2. The proposal removes much of the flexibility that the partner- 
ship tax provisions were designed to have, and consequently denies 
limited partnerships the ability to have their tax treatment paral- 
lel the complexities of the economic arrangements of the partners. 

3. The proposal is not needed because regulatory authority is al- 
ready provided to treat net income from limited partnerships as 
portfolio income under the passive loss rule. 



11. Depreciation Provisions 

a. Determine recovery period of property by reference to 
125 percent of lease or other contract term 

Present Law 

In general, under the Accelerated Cost Recovery System 
("ACRS"), property is assigned among recovery classes on the basis 
of midpoint lives under the prior law Asset Depreciation Range 
("ADR") system, as in effect on January 1, 1986. ADR midpoint 
lives were derived from data on how long taxpayers who provided 
information held the assets. The Treasury Department is author- 
ized to prescribe new ADR midpoints based on an asset's anticipat- 
ed "useful" life (rather than "service" life). 

Under the alternative depreciation system used for property for 
which which less generous depreciation is provided, the recovery 
periods used are also based on ADR midpoint lives. Property that is 
leased to or used by a tax-exempt person ("tax-exempt use proper- 
ty") is subject to the alternative depreciation system; however, the 
recovery period used is not less than 125 percent of the lease term 
if that period is longer than the depreciation period otherwise ap- 
plicable. 

ACRS deductions are allowed only to the owner of property for 
Federal income tax purposes. Although the determination of own- 
ership is inherently factual, general principles were developed in 
court cases, revenue rulings, and revenue procedures. These princi- 
ples focus on the economic substance of a transaction, not its form. 
Thus, in a purported lease or similar arrangement, the person 
claiming ownership must show that he has sufficient economic in- 
dicia of ownership. 

To give taxpayers guidance in structuring leveraged leases (i.e., 
leases in which the property is financed by a nonrecourse loan 
from a third party) of equipment, the Internal Revenue Service 
("IRS") issued revenue procedures (the "guidelines"). If the require- 
ments of the guidelines were met, the IRS generally issued an ad- 
vance letter ruling that the transaction was a lease and the lessor 
would be treated as the owner for Federal income tax purposes. 
Under the guidelines, the lessor must demonstrate that a remain- 
ing useful life of at least 20 percent of the originally estimated 
useful life of the property is the reasonable estimate of what the 
remaining useful life of the property will be at the end of the lease 
term. 

Possible Proposal 

For purposes of ACRS and all cases to which the alternative de- 
preciation system applies, determine the recovery period of proper- 
ty by reference to the longer of 125% of a lease (or other contract) 

(200) 



201 

term or the period that would otherwise apply. For purposes of this 
rule, include renewal options in the lease (or other contract) term. 

Pros and Cons 

Argument for the proposal 

In general, assets are assigned to ACRS classes by reference to 
economic lives. At present, the prior-law ADR system is utilized as 
the best available measure of economic lives, although the Treas- 
ury Department is authorized to refine ACRS classifications after 
additional study of the economic lives. The lessor of an asset 
cannot satisfy IRS ruling guidelines regarding the definition of a 
leveraged lease unless the asset's useful life is equal to at least 
125% of the lease term. Thus, in the case of an asset that is leased, 
the lease term provides independent evidence of the asset's mini- 
mal economic life. The term for which an asset is used under a 
service contract or financed provides similar evidence of economic 
life. 

Argument against the proposal 

The economic life of an asset is the same whether it is owned or 
leased by the user. The proposal would provide less generous depre- 
ciation for leased assets, and would discriminate against business 
enterprises that cannot afford to purchase equipment (because 
rentals would reflect the increased tax cost to the lessor). 

Revenue Effect 

[Fiscal years, billions of dollars] 
Proposal 1988 1989 1990 1988-90 

Extend recovery period to 125% of 
lease or other contract term 0.1 0.2 0.2 0.4 



b. Limitations on depreciation deductions for luxury auto- 
mobiles 

Present Law 

Depreciation deductions are subject to fixed dollar limitations for 
luxury automobiles. The limitations are $2,560 for the first taxable 
year in the recovery period, $4,100 for the second taxable year, 
$2,450 for the third taxable year, and $1,475 for each succeeding 
taxable year. The limitations are inapplicable to automobiles that 
are leased or held for leasing by any person regularly engaged in 
the business of leasing automobiles. A lessee's deductions for rent- 
als are subject to reduction but only if the lease term is 30 days or 
more. The surrogate limitation imposed on lessees requires the pre- 
scription of special tables by the Internal Revenue Service ("IRS"). 

Possible Proposal 

Impose the limitations for luxury automobiles directly on the 
owner of leased automobiles. 

Pros and Cons 
Arguments for the proposal 

1. Because the value of a very expensive automobile does not de- 
preciate as quickly as that of a less expensive car, the degree of ac- 
celeration under the Accelerated Cost Recovery System ("ACRS") 
would be greater for an expensive automobile that is leased but not 
subject to the luxury car limitations. The Congress determined that 
the investment incentive afforded by the ACRS should be directed 
to encourage capital formation rather than to subsidize the ele- 
ment of personal consumption associated with the use of expensive 
automobiles. These observations are equally applicable to automo- 
biles that are leased for personal use; however, the current statute 
does not reach this case. 

2. The imposition of a surrogate limitation on business lessees is 
inherently more complex than the rule that applies to owners of 
luxury automobiles. Under the current statute, the IRS is required 
to prescribe special tables, which provide for varying dollar limita- 
tions depending on factors such as the vehicle's fair market value, 
the number of days of the lease term included in the taxable year, 
and the amount of business use by the lessee. 

Arguments against the proposal 

1. The surrogate limitation imposed on lessees is substantially 
equivalent to imposing a limitation on the lessor. 

2. The imposition of a limitation on lessors would result in the 
payment of increased rentals by all lessees, and would unfairly 

(202) 



203 

burden lessees who do not deduct rentals because the leased auto- 
mobile is used only for personal purposes. 

Revenue Effect 

[Fiscal years, billions of dollars] 



Proposal 1988 1989 1990 1988-90 



Limitation on depreciation deduction 
for luxury autos (i) o.l 0.2 0.3 



' Gain of less than $50 million. 



c. Income forecast method of amortization 
Present Law 
Amortization of intangibles 

The Accelerated Cost Recovery System ("ACRS") does not apply 
to intangible assets. Amortization allowances are available for in- 
tangible assets of limited useful life that are used in a business or 
held for the production of income. Generally, amortization allow- 
ances are computed using a straight-line method. Certain income- 
producing properties, such as motion picture and television films, 
may be amortized under the income forecast method which allo- 
cates costs proportionately to income expected to be produced. 

Look-back method for long-term contracts 

A taxpayer using the percentage of completion method with re- 
spect to a long-term contract is required to determine upon comple- 
tion of the contract the amount of tax that would have been paid 
in each taxable year if the income from the contract had been com- 
puted by using the actual gross contract price and total contract 
costs, rather than the anticipated contract price and costs. Interest 
must be paid by the taxpayer if, applying this "lookback" method, 
there is an underpayment by the taxpayer with respect to a tax- 
able year. Similarly, under the "lookback" method, interest must 
be paid to the taxpayer by the Internal Revenue Service if there is 
an overpayment. The rate of interest for both underpayments and 
overpayments is the rate applicable to overpayments of tax (i.e., 
the short-term Federal rate plus 2 percentage points). 

Possible Proposal 

Require taxpayers using the income forecast method with respect 
to an item of property to determine at the end of the property's 
useful life (or, if earlier, at the end of a specified period, such as 
five years) the amount of tax that would have been paid in each 
taxable year if the amortization allowance had been computed by 
using the actual income derived from the property, rather than the 
forecasted income. Interest would be paid by the taxpayer if, apply- 
ing this "lookback" method, there is an underpayment by the tax- 
payer with respect to a taxable year, and interest would be paid to 
the taxpayer if, applying this "lookback" method, there is an over- 
payment. 

The "lookback" method could also be applied to other methods of 
depreciation or amortization that are not based on a useful life or 
recovery period, such as the unit-of-production method. 



(204) 



205 

Pros and Cons 
Arguments for the proposal 

1. The use of the income forecast method results in the deferral 
of tax if the forecasted income is less than the actual income de- 
rived from the property. Thus, taxpayers have an incentive to un- 
derestimate income that will be derived from the property in later 
years. The "lookback" method generally will recapture any defer- 
ral benefit and negate this incentive. 

2. The potential tax deferral available under the income forecast 
method may distort the allocation of capital and reduce economic 
efficiency. 

Arguments against the proposal 

1. The "lookback" method may generate additional complexity 
and uncertainty for the taxpayer, and add to the enforcement 
burden of the Internal Revenue Service. 

2. The application of the "lookback" method at the end of a spec- 
ified period is arbitrary and may not properly recapture the defer- 
ral benefit. 

Revenue Effect 

[Fiscal years, billions of dollars] 



Proposal 


1988 


1989 


1990 


1988-90 


Income forecast method of am- 
ortization 


(^) 


(1) 


(^) 


(1) 



^ Gain of less than $50 million. 



12. Foreign Tax Provisions 

a. Title passage source rule and 50-50 production/market- Jj 
ing split I 

Present Law 

F 
The foreign tax credit may eliminate the U.S. tax on "foreign 
source" income. That credit cannot reduce U.S. tax on "U.S. 
source" income. Therefore, to calculate the foreign tax credit, every ' 

item of income must have a source. ' 

1 

Title passage source rule | 

In general, income derived from the sale of personal property by " 
U.S. residents is U.S. source. Income attributable to the marketing 
of inventory property by U.S. residents, however, has its source at 
the place of sale, generally being where title to the property passes ' 
to the purchaser (the "title passage" rule). This title passage rule 
applies both to all income from the purchase and resale of invento- 
ry and to the marketing portion of income from the production of 
inventory property in the United States and marketing of that 
property abroad. 

Production/marketing split 

Income derived from the manufacture of products in the United 
States and their sale elsewhere is treated as having a divided 
source. Under Treasury regulations, 50 percent of such income gen- 
erally is attributed to the place of production, the United States, 
and 50 percent of the income is attributed to marketing activities 
and is sourced on the basis of the place of sale (determined under 
the title passage rule). The division of the income between produc- 
tion and marketing activities must be made on the basis of an inde- 
pendent factory price, rather than on a 50-50 basis, if such a price 
has been established. 

Study of title passage rule 

The 1986 Tax Reform Act directs the Treasury Department to 
study the effect of the title passage rule as it applies in determin- 
ing the source of the income from the sale of inventory property. 
That study is to take into account the Act's lower tax rates and 
Congressional trade concerns; the report arising from that study is 
due not later than September 30, 1987. 

1985 Administration Proposal 

Title passage source rule 

Under the Administration's 1985 tax reform proposal, adopted by 
the House bill but not contained in the Tax Reform Act of 1986, 

(206) 



207 

the title passage rule would be eliminated and gain from sales of 
inventory would be sourced in the seller's residence country. An 
exception to this general rule would apply if the seller maintains a 
fixed place of business outside the United States and that fixed 
placed of business participates materially in the sale generating 
the income. In such a case, marketing income would be sourced in 
the country where the fixed place of business is located. However, 
all income from sales to related foreign persons would be sourced 
in the United States even if the seller maintains a fixed place of 
business in another country. 

Production/marketing split 

The Administration did not propose a specific change in the 50/ 
50 formula for allocating income that arises from a combination of 
production and marketing activities to production and marketing, 
respectively. However, it did indicate that a fixed percentage allo- 
cating a greater portion of income to production than to marketing 
might be appropriate. 

Pros and Cons 
Arguments for the proposals 

1. The foreign tax credit's purpose is to prevent double taxation. 
Income that has a foreign source under the title passage rule is not 
likely to be taxed by any foreign country, so U.S. taxation of that 
income would not defeat the purpose of the foreign tax credit and 
would not create double taxation. 

2. The source rules for sales of personal property should reflect 
the location of economic activity generating the income. Determi- 
nation of source under the title passage rule and attribution of 50 
percent of income from production and marketing to the place of 
marketing do not reflect the economic activity generating the 
income. 

3. The Tax Reform Act's rate reductions tend to create excess 
foreign tax credits for U.S. taxpayers. Those excess foreign tax 
credits generated on income unrelated to sales of inventory proper- 
ty should not shelter income from sales of inventory property from 
tax. 

4. Export incentives should be targeted to all exporters, not just 
to exporters that have excess foreign tax credits that they can use 
to shelter export income from U.S. tax. 

Arguments against the proposals 

1. The current rules serve as a valuable export incentive and 
help promote international competitiveness. The tax burden on 
export income would increase if Congress adopted the 1985 Admin- 
istration proposal. At a time of large U.S. trade deficits, it would be 
unwise to reduce any export incentive. 

2. The current rules have worked well for many years. 

3. The current rules sometimes provide a result that is consistent 
with the economic activity test. 

4. Congress should delay consideration of any changes to the cur- 
rent rules until the completion of the Treasury Department's 
study. 



208 
Revenue Effect 

[Fiscal years, billions of dollars] 



Proposal 1988 1989 1990 1988-90 

Repeal title passage source rule 0.3 0.7 0.7 1.7 



b. Income from runaway plants 
Present Law 

U.S. persons that conduct foreign operations through a foreign 
corporation generally pay no U.S. tax on the income from those op- 
erations until the foreign corporation pays a dividend to its U.S. 
owners. The foreign tax credit may reduce or eliminate the U.S. 
tax on those dividends, however. 

Deferral of U.S. tax on income of a U.S. corporation's foreign 
subsidiary is not available for certain kinds of income, including 
"foreign personal holding company income" (such as interest and 
dividends, net gains from sales of stock and securities, and some 
rents and royalties), certain sales and services income, and certain 
other kinds of tax haven income. 

Possible Proposal 

Congress could repeal deferral for (that is, impose current tax on) 
income from "runaway plants," that is, income that a U.S. corpora- 
tion's foreign subsidiary earns from manufacturing goods for use or 
consumption in the United States. This income, as well as allocable 
interest and royalties paid by the foreign subsidiary, would be sub- 
ject to a separate foreign tax credit limitation, so that, for example, 
foreign taxes imposed on other income could not offset the U.S. tax 
on this income. 

Pros and Cons 
Arguments for the proposal 

1. When a U.S. enterprise manufactures goods for the U.S. 
market, it should be subject to the same tax burden whether that 
manufacturing takes place abroad or in the United States. 

2. The deferral or elimination of U.S. tax on income from manu- 
facturing abroad for the U.S. market can make it more advanta- 
geous for U.S. firms to manufacture in a low tax environment over- 
seas than in the United States. 

Arguments against the proposal 

1, In many cases, foreign-made goods will enter the U.S. market 
not because of tax factors but because of comparative economic ad- 
vantage (such as lower labor costs). The United States lacks tax ju- 
risdiction over foreign-owned producers of foreign goods. To subject 
U.S. owners of foreign subsidiaries that produce foreign goods to 
current U.S. tax will sometimes create a competitive disadvantage 
for those U.S.-controUed foreign corporations and a competitive ad- 
vantage for purely foreign producers of goods destined for the U.S. 
market. In some cases, a foreign corporation controlled by U.S. per- 
sons will perform some manufacturing abroad, while its U.S. owner 

(209) 



210 I 

performs subsequent manufacturing or processing with respect toj 
the same goods in the United States. To that extent, the U.S. com-| 
pany is creating U.S. employment despite use of a runaway plant. 
2. Administering special rules for income attributable to goods 
manufactured for the U.S. market could prove difficult. i 

Revenue Effect 

[Fiscal years, billions of dollars] 

I 

Proposal 1988 1989 1990 1988-90 ! 

. Il 

Tax income from runaway plants cur- j 

rently and impose separate foreign i 

tax credit limitation 0.1 0.2 0.2 0.6 



c. Withholding tax on interest paid to foreigners 
Present Law 

If a foreigner's U.S. source interest income is not effectively con- 
nected with a U.S. trade or business, it is exempt from U.S. tax if it 
(1) qualifies for a general Code exemption, added in 1984, that ap- 
plies to "portfolio interest," (2) is paid on a bank deposit, (3) consti- 
tutes short-term original issue discount, or (4) qualifies for a treaty 
exemption. 

Possible proposal 

Congress could impose a low-rate tax on U.S. source interest 
income paid to foreign investors. That tax could override treaties 
only in cases of "treaty shopping," that is, use of one country's 
treaty by persons who are not residents of that country. 

Pros and Cons 
Arguments for the proposal 

1. Like U.S. lenders, foreign lenders enjoy the income and securi- 
ty from investing in the United States and thus should not be 
exempt from paying U.S. tax on the income received, particularly 
since taxable U.S. borrowers reduce their U.S. tax by deducting the 
interest payments. 

2. Under current law, U.S. source interest income might not be 
taxed in any country. In that case, the borrower may deduct inter- 
est paid abroad, reducing domestic tax liability, with no offsetting 
increase in the tax base of any jurisdiction. Ultimately, unrestrict- 
ed cross-border lending could cause substantial tax base erosion in 
both the borrowing and lending countries. Treaty-shopping inves- 
tors are particularly unlikely to pay home country tax on U.S. 
source interest income. Also, as a result of enforcement difficulties, 
some tax-free debt might be held by U.S. persons evading U.S. tax. 

3. Tax exemption of interest paid to foreigners, instead of in- 
creasing foreign investment in the United States, may cause for- 
eigners to invest in U.S. debt instruments rather than other U.S. 
assets. 

4. Imposition of a withholding tax on interest paid to foreigners 
would tend to reduce worldwide demand for, and the value of, the 
dollar. A lower value for the dollar could increase U.S. exports, at 
least temporarily. 

Arguments against the proposal 

1. Many foreign countries do not tax interest paid to third-coun- 
try persons, so imposing the tax would place U.S. borrowers at a 
disadvantage against some foreign borrowers competing for the 
same dollars. Moreover, imposing the tax would not result in more 

(211) 



212 

I 
equitable tax treatment among lenders because foreign lenders will 
not pay U.S. tax on U.S. source interest income; they will instead i 
invest elsewhere. 

2. Tax exemption of interest paid to foreigners increases the 
inflow of capital into the United States and thus allows greater do- 
mestic investment at lower interest rates. A tax on this interest 
would be a barrier to international trade in assets, in the nature of 
a tariff. The United States should prefer foreign investment in the 
form of debt to other foreign investment, because lenders generally 
lack control over U.S. assets and activities. 

3. Imposition of a withholding tax on interest paid to foreigners 
could reduce net capital inflows and thus the value of the dollar. A 
lower value for the dollar could mean higher inflation, at least 
temporarily, as prices for imports rise. 

4. Imposition of a low-rate withholding tax on existing debt 
would frustrate the legitimate expectations of foreign investors. Im- 
position of the tax only on new debt or on newly acquired debt 
would raise little revenue in the short run. 

5. Overriding treaties, even in the case of treaty shopping, would 
break a U.S. commitment and offend our treaty partners. 

Revenue Effect 

[Fiscal years, billions of dollars] 
Proposal 1988 1989 1990 1988-90 

5. percent withholding tax on interest 
paid to foreigners (i) 0.2 0.3 0.5 

^ Gain of less than $50 million. 



d. Deduction for interest paid to exempt entities 
Present Law 

In theory, U.S. tax law does not distinguish between U.S. corpo- 
rations on the basis of ownership. That is, a U.S. corporation pays 
the same U.S. income tax whether its owners are Americans or for- 
eign persons, or whether its owners are taxable or tax exempt per- 
sons. 

In practice, however, a U.S. corporation that belongs to owners 
exempt from U.S. tax may deduct tax-free payments to them. For 
example, a foreign-owned U.S. corporation may be able to reduce 
its U.S. taxable income by making interest or royalty payments to 
related foreign persons. The payor can normally deduct those pay- 
ments from U.S. taxable income. (In 1984, Congress prohibited the 
accrual of interest deductions on obligations to related foreign par- 
ties until actual payment.) A U.S. income tax treaty (with the re- 
cipient's home country) may limit or even prohibit U.S. taxation of 
those payments in the hands of the recipient. 

In addition, characterization of payments that are contingent on 
an increase in value of an asset ("equity kickers") or on profits in 
excess of a stipulated amount ("net profits interest") as interest 
allows a foreign person to extract income realized in the United 
States in the form of deductible interest, which may be free of U.S. 
tax. By contrast, if the contingent payment is characterized as re- 
flecting equity ownership, some U.S. tax may be collected. 

A similar situation can arise in the case of U.S. tax exempt per- 
sons. For example, interest received by a U.S. charity from a less- 
than-80-percent-owned corporation is not unrelated business tax- 
able income. Thus, for example, if two unrelated U.S. charities 
each own half of a U.S. corporation, the corporation's interest pay- 
ments to them are not includible in income. 

A taxable U.S.-owned U.S. corporation, by contrast, generally 
cannot pay tax-free interest or royalties to its owners. In these 
cases, the United States collects one level of tax. Exceptions to this 
rule do exist, however. 

In 1969, Congress instructed the Treasury Department to pre- 
scribe regulations to determine whether an interest in a corpora- 
tion is stock or indebtedness for tax purposes. The Treasury has 
never issued these regulations in final form. Today, the determina- 
tion of a corporation's debt-equity ratio takes place on a case-by- 
case basis. 

Possible Proposals 

1. The deduction for interest payments to tax exempt owners of 
U.S. corporations could be limited. One alternative could be to 
treat some debt issued to these stockholders as stock if that debt is 

(213) 



214 

too great in proportion to equity. For example, some of the deduc- 
tion for interest paid to a related tax exempt person could be disal- 
lowed if the ratio of debt held by these stockholders to their equity 
exceeds 1 to 1 or some other ratio. Another alternative could be to 
deny a deduction for all or a portion of interest to the extent it is 
paid to related persons and is not included in income for U.S. pur- 
poses. (A provision similar to this alternative was included in the 
Senate amendment to H.R. 3838, the Tax Reform Act of 1986.) A 
third alternative could be to limit the debt-equity level of a U.S. 
subsidiary to that of its tax exempt owner. 

2. Deny interest treatment for payments that are contingent on 
an increase in the value of an asset or additional profits. 

Pros and Cons 
Arguments for the proposals 

1. Imposing interest limitations for tax exempt-owned U.S. corpo- 
rations would limit the "stripping" of earnings through deductible 
interest. 

2. Imposing limitations on interest deductibility would reduce the 
substantial tax incentive that present law provides for treaty-coun- 
try owners of U.S. corporations to capitalize those corporations 
with debt rather than equity. 

3. Imposing a debt-equity ratio for U.S. corporations owned by 
tax exempt entities would provide certainty to the often-disputed 
issue of what constitutes debt and equity. 

4. Reducing the deduction for interest to the extent it is not in- 
cluded in income for U.S. purposes would ensure that a deduction 
allowed against U.S. income will generally result in an inclusion 
for U.S. tax purposes. 

5. Treating contingent payments as payments on equity would 
ensure some U.S. tax from income realized from equity invest- 
ments in the United States. 

6. Limiting deductions for interest paid to foreign persons would 
follow the practices that some foreign countries use with respect to 
U.S.-owned corporations organized in those jurisdictions. 

Arguments against the proposals 

1. Unless the limitations on debt-financing apply to taxable U.S.- 
owned U.S. corporations, the limitations might violate U.S. trea- 
ties. 

2. Limiting debt-financing of foreign-owned U.S. corporations 
might cause foreign persons who own or who contemplate buying 
U.S. corporations to seek other investments. 

3. The inability of the Treasury Department and the IRS to issue 
final regulations to distinguish between debt and equity may indi- 
cate that a statutory debt-equity ratio is not wise. 

4. Even though interest payments to foreign persons may not be 
taxed by the United States, those payments generally are taxed in 
the persons' home countries, thus obviating the need, on grounds of 
equity, for imposition of United States tax. 

5. Imposing limitations on the deductibility of interest would 
frustrate the Treasury Department's efforts in removing similar 



215 

limitations imposed by foreign countries on U.S. persons doing 
business in those countries. 

6. Imposing limitations on the deductibility of interest paid only 
to related persons could result in use of back-to-back loans (for ex- 
ample, a loan by the related person to a third party and a subse- 
quent loan by the third party to the U.S. corporation) to avoid the 
limitations, thus increasing any administrative concerns associated 
with the proposal. 

Revenue Effect 

[Fiscal years, billions of dollars] 
Proposal 1988 1989 1990 1988-90 

Disallow deduction for interest paid to 
related tax-exempt entity to the 
extent total interest expense exceeds 
half of pre-interest deduction tax- 
able income and deny interest treat- 
ment for contingent payments (^) 0.1 0.1 0.2 

1 Gain of less than $50 million. 



74-267 - 87 - 



e. Treatment of South African income 
Present Law 

A credit against U.S. income tax is available for certain foreign 
taxes paid. The amount of the foreign tax credit may be reduced, 
however, in certain circumstances. For example, since 1978 a tax- 
payer that participates in or cooperates with an international boy- 
cott is denied a foreign tax credit for taxes paid on income derived 
within the countries associated with the boycott. 

Under provisions enacted in 1986, foreign tax credits also are 
denied with respect to income attributable to activities of the tax- 
payer conducted in a foreign country (1) that has been designated 
by the Secretary of State as a country that repeatedly provides sup- 
port for acts of international terrorism; (2) with which the United 
States does not have diplomatic relations, or (3) the government of 
which the United States does not recognize (with certain excep- 
tions). Countries that currently fall within one or more of these 
categories are Afghanistan, Albania, Angola, Cambodia, Cuba, 
Iran, Libya, North Korea, Syria, Vietnam, and South Yemen. 

Foreign taxes that are not creditable under the above rules are 
deductible. Income from activities in any country listed above is 
subject to a separate foreign tax credit limitation, so that taxes 
from other countries cannot offset the U.S. tax on that income. In 
addition, U.S. shareholders of a controlled foreign corporation are 
taxed currently on the corporation's income attributable to activi- 
ties conducted in these countries. 

In 1986 Congress enacted the Anti-Apartheid Act, imposing cer- 
tain economic measures on South Africa. These measures include 
prohibition of certain types of economic relationships with the 
South African government and certain business activities in South 
Africa, including a prohibition on new investment in South Africa 
(other than in a firm owned by black South Africans) by any U.S. 
national. Pursuant to the Anti-Apartheid Act, the income tax 
treaty and protocol between the United Sates and South Africa is 
terminated effective July 1, 1987. 

Possible Proposal 

Congress could subject South African operations to the same 
treatment currently given to operations in countries whose govern- 
ments support terrorism, do not have diplomatic relations with the 
United States, or are unrecognized by the United States. Thus, 
taxes on South African operations would not be creditable (but 
would be deductible), South African income would be subject to sep- 
arate foreign tax credit limitation treatment to prevent cross-cred- 
iting of excess foreign tax credits against the U.S. tax on South Af- 
rican income, and U.S. shareholders of controlled foreign corpora- 

(216) 



217 

tions would be subject to current taxation on corporate income de- 
rived from South Africa. 

Pros and Cons 
Arguments for the proposal 

1. It is the policy of the United States, as expressed in the Anti- 
Apartheid Act, to promote political, economic and social change 
leading to the dismantling of apartheid and the establishment of a 
nonracial, democratic political system in the Republic of South 
Africa. Congress has established a policy of encouraging reforms 
through economic measures, among other means, that are to be ad- 
justed to reflect progress or lack of progress made by the govern- 
ment of South Africa in meeting the goal of nonracial democracy. 

Denial of tax benefits for South African operations of U.S. enter- 
prises would serve purposes similar to those served by those meas- 
ures of the Anti-Apartheid Act terminating the South African tax 
treaty, prohibiting new investment and certain other economic ac- 
tivities in South Africa, and prohibiting certain transactions with 
the current government of South Africa. These purposes include re- 
ducing the ease and desirability of doing business in South Africa, 
reducing ties of mutual dependence between U.S. interests and 
South Africa's local pro-apartheid interests, and imposing disabil- 
ities on those who would otherwise transact business with the 
South African government. Were credits to be denied without also 
imposing current taxation of income, failure to remove both tax 
benefits simultaneously could vitiate the effects of denying the 
credits. As is the case with the economic measures in the Anti- 
Apartheid Act, the proposed tax changes could be adjusted at a 
later date to reflect the South African government's future 
progress or lack of progress in dismantling apartheid. 

2. Similarly, Congress has seen fit to express disapprobation of 
government-sponsored international terrorism, and other activities 
of foreign governments disruptive of international peace and stabil- 
ity, by denying deferral of U.S. tax, and denying credits for foreign 
tax, on income from activities in those countries. South African ad- 
herence to apartheid puts it in the same class as the countries cov- 
ered by these existing tax provisions. 

Arguments against the proposal 

1. The presence of U.S.-owned business in South Africa, and the 
accompanying degree of U.S. influence in that country, may be a 
positive factor in the day-to-day lives of the victims of apartheid 
and in the longer-term cause of ending apartheid. The proposal is a 
broad-based escalation of the economic measures in the Anti- Apart- 
heid Act, which would tend to further impair the conditions under 
which the majority of South African citizens live and reduce U.S. 
influence in South Africa. These are punitive measures better re- 
served for use at a future date (if ever) when it is clear that there 
are no longer any positive ends to be served by U.S.-owned busi- 
nesses working within South Africa. 

2. Tax policy generally is better served by tax laws that are not 
devices of nontax policy. This was a dominant theme of the Tax 
Reform Act of 1986. Congress enacted that law, in part, because 



218 

pre-Reform Act tax rules aimed at affecting economic decisions j 
were found to reduce economic efficiency and impair the perceived | 
fairness of the U.S. tax system. The estabhshed anti-apartheid for- ) 
eign policy of the United States is more effectively promoted by ' 
nontax measures that can be carefully targeted to changing foreign 
policy events and do not involve the IRS in foreign policy imple- 
mentation. Foreign policy concerns may require a more flexible re- 
sponse than can be achieved with tax Code modifications. 

Revenue Effect i 

[Fiscal years, billions of dollars] j 

Proposal 1988 1989 1990 1988-90 

Treat South African income like 
income from countries that the ( 

United States does not recognize (^) (^) (i) 0.1 

^ Gain of less than $50 million. 



f. Foreign earned income exclusion 
Present Law 

A U.S. citizen or resident is generally taxed on his or her world- 
wide income, with the allowance of a foreign tax credit for foreign 
taxes paid on the foreign income. However, under present and 
prior Code section 911, an individual who has his or her tax home 
in a foreign country and who either is present overseas for 330 
days out of 12 consecutive months or is a bona fide resident of a 
foreign country for an entire taxable year generally can elect to ex- 
clude $70,000 of his or her foreign earned income from his gross 
income for taxable years beginning after 1986. The maximum ex- 
clusion was $80,000 in 1986. The exclusion does not apply to earn- 
ings of U.S. employees. 

In addition to the exclusion, an individual meeting the eligibility 
requirements generally may also elect to exclude (or deduct, in cer- 
tain cases) housing costs above a floor amount. 

Possible Proposal 

Congress could reduce the maximum foreign income exclusion 
amount. 

Pros and Cons 
Arguments for the proposal 

1. U.S. citizens who live and work abroad obtain an unwarranted 
tax advantage over those who live and work in America. There 
should be no incentive for U.S. citizens to work outside the United 
States. 

2. U.S. citizens who live and work abroad should contribute to 
the deficit reduction effort. 

3. With the low U.S. individual tax rates, many U.S. citizens who 
live and work abroad obtain exemption from U.S. tax through the 
foreign tax credit thus eliminating the usefulness of the income ex- 
clusion. 

4. Some U.S. citizens work abroad for manufacturers that import 
goods into the United States or that compete in foreign markets 
against U.S. exports. To that extent, they have a negative effect on 
the U.S. balance of trade. Some other U.S. citizens who work 
abroad have no effect on the balance of trade. 

Arguments against the proposal 

1. U.S. exports are greater when U.S. individuals, who are most 
famihar with U.S.-made products and services, work abroad. 
Absent a significant tax benefit, it would be more difficult to find 
Americans to work abroad. Moreover, elimination of the exclusion 
would result in higher labor costs for U.S. firms operating overseas. 

(219) 



220 

2. Foreign countries, unlike the United States, generally exempt 
their citizens' foreign earnings. 

3. Americans abroad need special tax treatment because they 
must pay from personal funds for some services normally borne by 
State or local governments in the United States, such as schooling 
for dependents. 

Revenue Effect 

[Fiscal years, billions of dollars] 



Proposal 


1988 


1989 


1990 


1988-90 


Reduce foreign income exclusion to 
$50,000 


0.1 


0.1 


0.1 


0.4 







13. Insurance and Annuities 

a. Life insurance policies; including single premium or in- 
vestment-oriented policies 

Present Law 
Tax treatment of policyholders 

Treatment of investment income 

Life insurance contracts. — Under present law, the investment 
income ("inside buildup") earned on premiums credited under a life 
insurance policy generally is not subject to current taxation to the 
owner of the policy. 

The favorable tax treatment is available only if a life insurance 
contract meets certain requirements designed to limit the invest- 
ment character of the contract. Under present law, a life insurance 
contract is eligible for favorable tax treatment to the policyholder 
if it meets either of two statutory tests: the "cash value accumula- 
tion" test, or the "guideline premium/ cash value corridor" test. A 
contract generally meets the cash value accumulation test if the 
cash surrender value cannot exceed the net single premium that 
would have to be paid at that time to fund future benefits under 
the contract. A contract generally meets the guideline premium/ 
cash value corridor test if the premiums paid under the policy do 
not exceed certain guideline levels, and the death benefit under the 
policy is not less than a varying statutory percentage of the cash 
surrender value of the policy. Adjustment rules provide that cash 
distributions resulting from reductions in benefits in the first 15 
years of the policy are subject to tax (up to a ceiling amount). 

Under these rules, investment income on a life insurance policy 
that has too large an investment component is treated as ordinary 
income received or accrued by the policyholder during the year. 

Annuity contracts. — Under present law, the investment income 
("inside buildup") earned on premiums credited under an annuity 
contract held by an individual is not subject to current taxation in 
the hands of the owner of the contract. 

Present law (as amended by the 1986 Act) provides, however, 
that the income on a deferred annuity contract for any taxable 
year is treated as ordinary income received or accrued by the con- 
tract owner, if the contract is held by a person who is not a natural 
person (such as a corporation). Certain exceptions are provided for 
such contracts that are held (1) under qualified plans, (2) as quali- 
fied funding assets under structured settlement arrangements, and 
(3) in certain other circumstances. The requirement of inclusion of 
income on a deferred annuity contract also does not apply to imme- 
diate annuities (generally, those annuities under which the annuity 

(221) 



222 

starting date is no more than a year after the purchase of the an- 
nuity). 

Thus, other than in the case of a deferred annuity held by a non- 
natural person, tax generally is deferred on the inside buildup 
under an annuity contract. An immediate annuity offers a deferral 
of tax to the extent that the premium paid in any year exceeds the 
premium necessary to provide annuity income during that year. In 
the case of a deferred annuity contract held by an individual, defer- 
ral of tax on the investment income earned on the contract occurs 
throughout the period prior to the time that all obligations under 
the contract are satisfied. 

Treatment of payments under insurance or annuity contracts 

Life insurance policies. — Under a life insurance contract, all 
death benefits are excluded from income, so that neither the policy- 
holder nor the policyholder's beneficiary is ever taxed on the inside 
buildup if the proceeds of the policy are paid to the policyholder's 
beneficiary by reason of the death of the insured. 

Distributions from a life insurance contract that are made prior 
to the death of the insured generally are includible in income, but 
only to the extent that the amounts distributed exceed the taxpay- 
er's basis in the contract. Distributions are generally treated first 
as a tax-free recovery of basis, and then as income. 

Annuity contracts. — In the case of an annuity contract (whether 
immediate or deferred), amounts received after the annuity start- 
ing date generally are includible in income. However, under such a 
contract, the individual's investment in the contract is recovered 
on a pro-rata basis over the individual's life expectancy. 

By contrast, distributions under an annuity contract prior to the 
annuity starting date are treated as currently taxable to the extent 
of the previously untaxed income on the contract. Thus, income 
earned on the contract is subject to tax when distributed (or as it is 
earned, in the case of deferred annuities held by persons other 
than natural persons, such as corporations). 

Borrowing under insurance or annuity contracts 

Life insurance policies. — The inside buildup on a life insurance 
contract generally is not treated as distributed to the policyholder 
and subject to current taxation if the policyholder borrows under 
the policy or receives distributions under it, to the extent of the 
policyholder's basis in the policy, even though the policyholder has 
current use of the money. 

Under present law, as amended by the 1986 Act, interest on 
amounts borrowed under a life insurance policy for personal ex- 
penditures is treated as nondeductible personal interest (subject to 
a phase-in rule for taxable years beginning in 1987 through 1990). 
Present law also treats as nondeductible the interest on debt with 
respect to policies covering the life of an officer, employee or indi- 
vidual financially interested in the taxpayer (to the extent the debt 
exceeds $50,000 per officer, employee or individual). 

Policyholder loans at low or no net interest rates are not specifi- 
cally subject to the below-market loan rules under present law. 



223 

Annuity contracts. — Amounts borrowed from a deferred annuity 
contract are treated as distributions under the contract and are 
treated as received first out of income on the contract. 

Tax treatment of insurance companies 

Under present law, a life insurance company generally is not 
subject to tax on the inside buildup on a life insurance or annuity 
contract because of the life insurance company reserve rules. 
Under these rules, a life insurance company is allowed a deduction 
for a net increase in life insurance reserves (taking into account 
both premiums and assumed interest credited to the reserves). Life 
insurance reserves are defined to include amounts set aside to 
mature or liquidate future unaccrued claims arising from life in- 
surance, annuity, and noncancellable accident and health insur- 
ance contracts that involve, at the time with respect to which the 
reserve is computed, life, accident, or health contingencies. 

The maximum reserve permitted under present law with respect 
to a contract equals the greater of (1) the net surrender value of 
the contract or (2) the Federally prescribed tax reserve. The as- 
sumed interest rate to be used to discount future obligations in 
computing the Federally prescribed reserve is the prevailing State 
assumed interest rate (generally, the highest rate for computing in- 
surance reserves under the state insurance laws of 26 or more 
states). By contrast, under present law, tax reserves for unpaid 
losses of property and casualty insurance companies are subject to 
discounting by applying the applicable Federal rate (AFR) of inter- 
est (specifically, the average of the applicable Federal mid-term 
rates for the most recent 60-month period beginning after July, 
1986). 

Present law does not treat reserve deductions of insurance com- 
panies as an item of tax preference under the corporate alternative 
minimum tax. 

Possible Proposals 

Life insurance contracts 

1. As proposed by the President in his 1985 tax reform proposal, 
the inside buildup on newly-issued life insurance policies could be 
included in the income of the policyholder. Thus, the policyholder 
would include in income for a taxable year any increase (other 
than through unrealized appreciation, in the case of variable con- 
tracts) during the year in the amount by which the policy's cash 
value exceeds the policyholder's investment in the contract. 

Alternatively, the inclusion in income of the inside buildup on 
newly-issued life insurance policies could apply only to policies held 
by persons other than natural persons. 

2. The definition of life insurance could be narrowed for newly 
issued policies to provide that significantly investment-oriented life 
insurance policies such as single-premium life insurance policies 
would not be treated as life insurance policies for Federal income 
tax purposes and, therefore, that investment earnings on the policy 
would be currently included in the policyholder's income. For ex- 
ample, if the amount of the premium in any year substantially ex- 
ceeds the amount needed for level premium funding of the death 



224 

benefit, or the income earned on the contract is from high-risk or 
high-return investments, then the contract would not be treated as 
life insurance. 

Alternatively, only the excess investment income could be taxed 
currently with respect to newly issued policies. 

3. Distributions from newly issued life insurance policies prior to 
the death of the insured could be treated in the same manner as 
distributions under annuity contracts prior to the annuity starting 
date (i.e., income first). 

Annuity contracts 

1. As proposed by the President's tax reform proposal of May 
1985, newly issued deferred annuity contracts held by natural per- 
sons could be treated the same as such contracts held by persons 
other than natural persons, so that income on the contract for any 
year would be treated as ordinary income received or accrued by 
the policyholder during the year. 

2. The amount that a policyholder could invest in a newly issued 
deferred annuity contract on a tax-favored basis could be subject to 
a cap, such as $50,000. Inside buildup on amounts invested in 
excess of $50,000 could be currently taxable to the policyholder. 

Borrowing under life insurance contracts 

1. New loans under life insurance policies could receive the same 
treatment as loans under annuity contracts (i.e., could be treated 
as distributions under the policy prior to the death of the insured). 

2. Low or no net interest policyholder loans could be treated as 
below-market loans and the foregone interest on the loans could be 
treated as a distribution of income on the contract to the policy- 
holder. 

Treatment of insurance company 

1. As proposed by the President's tax reform proposal of May 
1985, a life insurance company could be prohibited from deducting 
increases to reserves for newly-issued life insurance or annuity con- 
tracts to the extent that the reserve exceeds the cash surrender 
value of a contract. 

2. Life insurance companies could be prohibited from taking de- 
ductions for life insurance reserves (but not reserves for losses 
which have actually occurred) with respect to all newly issued in- 
surance and annuity contracts, and instead could be permitted to 
deduct amounts only when a death or distribution creates a liabil- 
ity with respect to such contracts. 

3. The deduction for life insurance reserves could be treated as 
an item of tax preference (i.e., not permitted as a deduction) under 
the corporate alternative minimum tax. 

4. If deductions for life insurance reserves are not otherwise lim- 
ited, the interest rate applicable in determining Federally pre- 
scribed tax reserves of life insurance companies could be conformed 
to the applicable Federal rate (AFR) (similar to the discount rate 
for other insurance companies). 



225 

Pros and Cons 
Arguments for the proposals 

1. The tax treatment of life insurance companies and their pol- 
icyholders results in a total exemption from tax of a substantial 
amount of investment income. This exemption increases the unfair- 
ness and inefficiency of the tax system. 

2. Life insurance companies have more favorable tax treatment 
with respect to their liabilities than other financial intermediaries 
because they can deduct liabilities that have not yet accrued under 
generally applicable tax accounting principles. Most companies are 
not allowed reserves for future expenses; even property and casualty 
insurance companies are not allowed a reserve deduction until a 
loss actually occurs (e.g., a disability occurs or a fire or theft takes 
place). Life insurance companies thus have an unfair tax advan- 
tage. 

3. It is inappropriate to allow life insurance companies a deduc- 
tion for amounts credited to policyholders until an amount is in- 
cluded in their income, as is the case with other financial interme- 
diaries. 

4. The deferral of tax on the inside buildup of life insurance poli- 
cies primarily benefits higher-income taxpayers who are able to 
save yet who do not need a tax-motivated incentive to save. Present 
law thus reduces the progressivity of the income tax. 

5. Tax-free inside buildup of life insurance policies and annuities, 
unlike tax-favored mechanisms for providing retirement benefits, is 
not subject to restrictions (such as nondiscrimination rules or con- 
tribution or income limits). Thus, continued allowance of tax ad- 
vantages circumvents important rules applicable to qualified plans 
and IRAs. 

6. Whole life insurance policies frequently are surrendered by 
the policyholder for their cash value or are encumbered by exten- 
sive borrowing which reduces death benefits and, therefore, do not 
serve a possible public policy of providing for dependents in the 
event of the insured's death. Thus, investment-oriented life insur- 
ance policies are inconsistent with Congressional intent to provide 
that death benefits are funded through tax-favored inside buildup. 

7. In the 1986 Act, Congress expressed a policy concern about op- 
portunities for tax sheltering, and restrictions on life insurance 
and annuities would be consistent with this concern by eliminating 
an opportunity for some taxpayers to shelter income by investing 
in single premium life insurance and deferred annuity contracts. 

8. Loans from life insurance contracts often are substantively 
equivalent to a distribution from the contract prior to the death of 
the insured because loans are frequently not repaid by the policy- 
holder. Thus, if distributions prior to the death of the insured are 
treated as a return of income first under the contract, then equiva- 
lent treatment is appropriate for policy loans. 

9. Limiting the life insurance company reserves for any contract 
to the cash surrender value of the contract would prevent the over- 
statement of tax reserves. Cash surrender value is an objective 
measure of the reserve for policyholder claims, while reserves com- 
puted for State regulatory purposes are computed using conserva- 
tive assumptions. 



226 

10. Because the interest rates set by State insurance law are not 
designed to measure income but rather to keep reserves high 
enough to encourage insurance company solvency, using State 
rates tends to overstate reserves and hence to understate life insur- 
ance company income, giving an unintended tax benefit to life in- 
surance companies. 

Arguments against the proposals 

1. Encouraging people with disposable income to provide finan- 
cially for their dependents in the event of death is an important 
social policy that should be supported by the tax incentive of per- 
mitting tax-free inside buildup of life insurance policies and annu- 
ities. 

2. Treating inside buildup of life insurance policies as currently 
taxable to the policyholder would effectively raise the cost of pro- 
viding insurance coverage and would discourage its purchase, possi- 
bly raising the government's cost of providing social services gener- 
ally. 

3. The proposal to tax currently inside buildup on life insurance 
and annuities would tax policyholders on income they have not yet 
received. 

4. The effect of limiting the reserve deduction for a life insurance 
company is to tax the company on part of the inside buildup alloca- 
ble to the policyholder. It is unfair to impose greater tax on a life 
insurance company merely because the inside buildup on a con- 
tract is not taxed currently to the policyholder. 

5. It is unfair and unwise to deny insurance companies a deduc- 
tion for reserves they are required to maintain under State law. 
Moreover, denial of a reserve deduction could lead to pressure to 
reduce State reserve requirements, which would increase the risk 
that policyholders will not be able to recover their claims from the 
company. 

6. Whole life insurance and deferred annuity contracts provide a 
vehicle by which individuals who do not participate in a qualified 
pension plan may fund adequate amounts of future retirement 
income and security for their dependents on a tax-favored basis. 
Many employers do not have adequate pension plans, and it would 
be unfair to deny these t£ix advantages to those who cannot obtain 
them through their employer plans. 

7. The perceived unfair tax advantage of life insurance policies 
and deferred annuities is not generated by excessive investment 
orientation, but rather is the result of overzealous or unscrupulous 
advertising by some members of the insurance industry. 

8. Treating loans from life insurance contracts as taxable distri- 
butions from the contracts ignores the economic reality of the 
transaction in which the policyholder in fact suffers a detriment if 
the loan is not repaid. 

9. The prevailing State rates are not significantly different from 
the applicable Federal rate, and thus there is little substantive 
effect in changing the applicable rate for discounting life insurance 
reserves. 



227 
Revenue Effect 

[Fiscal years, billions of dollars] 



Proposal 



1988 1989 1990 1988-90 



Life insurance policies; including 
single premium or investment-ori- 
ented policies: 

(1) Tax inside buildup on new life 
insurance policies 0.1 

(2) Modify definition of invest- 
ment-oriented insurance 0.1 

(3) Treat surrenders on life insur- 
ance as income 

(4) Tax inside buildup on deferred 
annuities 

(5) $50,000 cap on tax-favored de- 
ferred annuities 

(6) Loans from life insurance poli- 
cies treated as distributions 0.2 

(7) Below market loans 

(8) Deduction for reserves limited 
to surrender value 

(9) Deny reserve deductions for 
new life insurance and annuity 
contracts 0.2 

(10) Treat life insurance reserves 
as preference items for mini- 
mum tax (^) 

(11) Require use of AFR for re- 
serve deductions 0.1 



0.3 


0.4 


0.7 


0.1 


0.2 


0.4 


(') 


0.1 


0.1 


0.1 


0.2 


0.3 


(') 


{') 


0.1 


0.3 


0.3 
0.1 


0.7 
0.1 


0.1 


0.1 


0.2 


0.3 


0.4 


0.9 


0.1 


0.1 


0.2 


0.1 


0.1 


0.2 



^ Gain of less than $50 million. 



b. Life insurance company consolidation 
Present Law 

Under present law, if one or more life insurance companies file a 
consolidated return with one or more nonlife insurance companies, 
a special rule limits the use of certain losses against the income of 
the life insurance affiliates. The limitation is equal to the lower of 
(1) 35 percent of the consolidated net operating loss of the nonlife 
insurance affiliates, or (2) 35 percent of the taxable income of the 
life insurance company affiliates. 

Income from foreign life insurance corporations that are owned 
by nonlife insurance affiliates is not treated as life insurance affili- 
ate income for purposes of the loss limitation. 

Possible Proposal 

Income from controlled foreign life insurance corporations could 
be treated as life insurance affiliate income for purposes of the loss 
limitation. 

Pros and Cons 
Arguments for the proposal 

1. Present law creates an incentive for a domestic life insurance 
company to transfer ownership of its foreign life insurance corpora- 
tions to its domestic nonlife affiliates in order to avoid the limita- 
tion on the use of nonlife losses against life insurance company 
income. 

2. Present law may create an incentive to transfer domestic life 
insurance business to a controlled foreign life insurance corpora- 
tion to avoid the loss limitation. 

Arguments against the proposal 

1. A foreign corporation may not enter into a consolidated return 
with a domestic life insurance corporation so that it is inappropri- 
ate to treat the income of a controlled foreign life insurance corpo- 
ration as income of a life insurance affiliate. 

2. Life insurance companies are the only taxpayers that cannot 
fully consolidate nonlife losses under present law. Extending the 
loss limitation to income from a controlled foreign life insurance 
corporation would aggravate the present law discriminatory treat- 
ment. 



(228) 



229 
Revenue Effect 

[Fiscal years, billions of dollars] 



Proposal 1988 1989 1990 1988-90 

Life insurance company consolidation .... (i) (i) (i) 0.1 

* Gain of less than $50 million. 



c. Treatment of nonproHt insurance providers 
Present Law 

Present law (as amended by the 1986 Act) provides that an orga- 
nization described in sections 501(c)(3) or (4) of the Code is exempt 
from tax only if no substantial part of its activities consists of pro- 
viding commercial-type insurance. For this purpose, commercial- 
type insurance generally is any insurance of a type provided by 
commercial insurance companies. The 1986 Act did not, however, 
alter the tax-exempt status of an ordinary health maintenance or- 
ganization (i.e., any health maintenance organization, tax-exempt 
under prior law, which is substantially the same as a Federally 
chartered health maintenance organization), that provides health 
care to its members predominantly at its own facility through the 
use of health care professionals and other workers employed by the 
organization. 

Present law also provides special treatment for existing Blue 
Cross or Blue Shield organizations and other organizations that 
meet certain requirements and substantially all of whose activities 
are providing health insurance. Generally, such organizations are 
treated as stock property and casualty insurance companies. A spe- 
cial deduction is provided to such organizations with respect to 
their health business equal to 25 percent of the claims and ex- 
penses incurred during the taxable year less the adjusted surplus 
at the beginning of the year. In addition, such organizations are 
given a fresh start with respect to changes in accounting methods 
resulting from the change from tax-exempt to taxable status. Fur- 
ther, such organizations are not subject to the treatment of un- 
earned premium reserves generally applicable to property and cas- 
ualty insurance companies. Finally, the basis of assets of such orga- 
nizations is equal, for purposes of determining gain or loss, to the 
amount of the assets' fair market value on the first day of the orga- 
nization's taxable year beginning after 1986. 

Possible Proposals 

1. The special deduction for existing Blue Cross/Blue Shield orga- 
nizations could be repealed. 

2. The tax exemption for health maintenance organizations 
(HMOs) could be repealed. 

3. Health maintenance organizations could be given the same 
treatment as existing Blue Cross and Blue Shield organizations 
(i.e., they would not be entitled to tax-exempt status, but they 
would be eligible for the special Blue Cross/Blue Shield deduction). 



(230) 



231 

Pros and Cons 
Arguments for the proposals 

1. Health maintenance organizations commonly are structured so 
that their operation is essentially equivalent to providing insur- 
ance coverage for medical expenses, and it is unfair to give them 
more favorable tax treatment than other providers of health insur- 
ance coverage. 

2. Continuing exempt status for health maintenance organiza- 
tions gives them an undesirable competitive advantage, not only 
over taxable insurers providing comparable coverage of medical ex- 
penses, but also over taxable health service providers providing 
similar medical services. 

3. The special 25-percent of claims expense deduction for Blue 
Cross/Blue Shield organizations creates a competitive advantage 
for the health insurance business of these organizations compared 
to the health insurance business of other insurance companies. 

Arguments against the proposals 

1. Health maintenance organizations are service providers as 
well as insurers, and taxing them on the grounds that they operate 
in a manner equivalent to insurers is unfair. 

2. Taxing health maintenance organizations like insurance com- 
panies would in many instances prove administratively cumber- 
some. 

3. Taxing health maintenance organizations, even if they are 
given special tax advantages, contravenes Congressional policy to 
promote that form of providing health services or coverage by 
granting the provider organizations tax-exempt status. 

4. Existing Blue Cross/Blue Shield organizations typically pro- 
vide health insurance coverage to individuals and small groups 
who might not otherwise be able to purchase such coverage from 
other insurance companies. A significant increase in the tax liabil- 
ity of such an existing Blue Cross/ Blue Shield organization might 
force the organization to drop this special coverage. 

Revenue Effect 

[Fiscal years, billions of dollars] 
Proposal 1988 1989 1990 1988-90 

Treatment of nonprofit insurance pro- 
viders: 

(1) Repeal special deduction for 
Blue Cross/Blue Shield (M 

(2) Repeal tax exemption for 
HMOs (1) 

(3) Allow HMOs to claim Blue 
Cross/Blue Shield deduction (^) 

* Gain of less than $50 million. 



(^) 


0.1 


0.1 


(^) 


0.1 


0.1 


{') 


0.1 


0.1 



d. Treatment of foreign life insurance companies 
Present Law 

In the case of a foreign life insurance company, present law re- 
quires that income effectively connected with the conduct of an in- 
surance business in the United States be increased by an imputed 
amount to the company, if its surplus held in the United States is 
insufficient in relation to a percentage of its total insurance liabil- 
ities on its United States business. The effect of this imputation 
rule is to prevent foreign companies from artificially reducing the 
amount of investment income subject to tax in the United States. 
Under the imputation rule, if the required United States surplus 
exceeds the company's actual United States surplus, the company 
must increase its income by the product of that excess and its cur- 
rent investment yield on assets held in the United States. For pur- 
poses of this calculation, a company's surplus held in the United 
States is the excess of its assets held in this country over its total 
insurance liabilities on United States business. 

Some foreign life insurance companies may have been seeking to 
avoid the effect of the provision by incurring large, short-term non- 
insurance liabilities at the end of the year. This practice (e.g., bor- 
rowing a large sum for a short period such as a week) could have 
the effect of increasing assets by the borrowed amount without any 
corresponding increase in insurance liabilities. In addition, a com- 
pany may seek to avoid the provision by holding assets in the 
United States that have a low current investment yield and sub- 
stantial unrealized appreciation, which has the two-fold effect of in- 
creasing United States assets (which, in the case of real property 
and stock, are valued at market value), and decreasing the current 
investment yield on those assets. 

Possible Proposal 

The imputation rule could be clarified to provide that it take into 
account the excess of a company's United States assets over its 
total United States liabilities, not just its insurance liabilities, and 
that unrealized appreciation in the assets is not taken into account. 
In addition, the investment yield taken into account could be the 
investment yield on all assets of the entire company, so that the 
selection of low-yielding assets to hold in the United States would 
be irrelevant. 

Alternatively, the investment yield on United States assets could 
take into account in determining the amount of any unrealized ap- 
preciation in the assets during the year. 



(232) 



233 

Pros and Cons 
Arguments for the proposal 

1. The proposal eliminates possible loopholes that would make 
the imputation provision avoidable at will. 

2. The proposal cuts back an unintended and unfair competitive 
advantage that foreign life insurance companies insuring United 
States risks have over purely domestic companies insuring such 
risks. 

Arguments against the proposal 

1. The proposal could discourage foreign life insurance companies 
from insuring and reinsuring United States risks and, thus, could 
make life insurance scarcer and more expensive in the United 
States. 

2. The proposal could prompt foreign jurisdictions to take retalia- 
tory measures against United States insurers operating abroad, 
and, thus, could hurt United States international competitiveness 
as well as disrupting international insurance and reinsurance mar- 
kets. 

Revenue Effect 

[Fiscal years, billions of dollars] 
Proposal 1988 1989 1990 1988-90 

Treatment of foreign 
life insurance 
companies (^) (i) (^) (^) 

^ Gain of less than $50 million. 



e. Minimum tax treatment of mutual life insurance compa- 
nies 

Present Law 

Among the preference items taken into account in computing the 
corporate alternative minimum tax (as amended by the 1986 Act) is 
the amount determined by comparing the adjusted net book income 
of the taxpayer with its unadjusted alternative minimum taxable 
income (the "book income" preference). In general, the book 
income used in computing the adjusted net book income of a corpo- 
rate taxpayer is the net income or loss set forth on the taxpayer's 
applicable financial statement, with certain conforming adjust- 
ments. The applicable financial statement is the statement it pro- 
vides for regulatory or credit purposes, for the purpose of reporting 
to shareholders or other owners, or for other substantial nontax 
purposes. In the case of a corporation that has more than one fi- 
nancial statement, rules of priority are provided for the determina- 
tion of which statement is to be considered as the applicable finan- 
cial statement for the purpose of determining net book income. 

In the case of a mutual insurance company subject to regulation 
under State insurance laws, the applicable financial statement is 
likely to be the statement that the company files with the State in- 
surance regulatory authority, as a mutual company does not have 
shareholders and consequently does not provide a financial state- 
ment for shareholders. Stock life insurance companies, on the other 
hand, generally do report to shareholders, and consequently the ap- 
plicable financial statement for such companies is likely to be the 
statement provided to their shareholders. 

For tax purposes, but not for financial reporting purposes, 
mutual companies are required to include in income the differen- 
tial earnings amount, an amount intended to take account of the 
deductibility to mutual companies of policyholder dividends. This 
addition to Federal taxable income is not normally permitted to be 
included in the amount reported by a mutual insurance company 
on its applicable financial statement. Thus, generally, under the 
book income preference, mutual companies are likely to have a 
smaller difference between book income and alternative minimum 
taxable income than are stock companies, and consequently are 
less likely than stock companies to incur tax liability under the 
corporate alternative minimum tax. 

Possible Proposal 

An adjustment could be added to the calculation of book income 
of mutual life insurance companies to include the differential earn^ 
ings amount in their book income. 

(234) 



235 

Pros and Cons 
Argument for the proposal 

1. The proposal would eliminate the unfair advantage of mutual 
life insurance companies over stock life insurance companies under 
the book income provision, and would prevent the mutual compa- 
nies from, in effect, enjoying a reduction in the book income prefer- 
ence. 

Argument against the proposal 

1. The intention of the book income provision is to take into ac- 
count a corporation's income for financial reporting purposes, with- 
out any adjustments; such adjustments are both unnecessary and 
complex. 

Revenue Effect 

[Fiscal years, billions of dollars] 
Proposal 1988 1989 1990 1988-90 

Minimum tax 
treatment of mutual 
life companies (^) (^) 0.1 0.1 

^ Gain of less than $50 million. 



f. Treatment of certain insurance syndicates 
Present Law 

Present law provides that property and casualty insurance com- 
panies (whether stock or mutual) include in income the underwrit- 
ing income or loss and the investment income or loss, as well as 
gains and other income items. Premium income of such taxpayers, 
for example, is included annually in taxable income, and deduc- 
tions (e.g., for 80 percent of the increase in unearned premiums, 
and for the discounted amount of loss reserves) are allowed annual- 
ly in calculating the taxable income. 

Pursuant to a closing agreement between the IRS and the mem- 
bers of an insurance organization formed under the laws of the 
United Kingdom, these members are provided a three-year deferral 
of underwriting income or loss, consistent with the organization's 
traditional accounting method. 

Possible Proposal 

In the case of a person who is a member of an organization 
formed under the laws of the United Kingdom to write insurance 
or reinsurance, the deferral currently allowed pursuant to the clos- 
ing agreement could be prohibited. Income and loss would be calcu- 
lated annually in accordance with the principles generally applica- 
ble to property and casualty insurance companies. 

Pros and Cons 
Argument for the proposal 

1. The proposal would treat all persons engaged in insuring or 
reinsuring risks equally, instead of giving certain members of in- 
surance syndicates an unfair tax-created competitive advantage. 

Argument against the proposal 

1. The proposal would abrogate an express agreement entered 
into to match the tax treatment of members of the insurance syndi- 
cates to the economic arrangements; and thereby could provoke re- 
taliatory United Kingdom tax rules that would disrupt internation- 
al insurance and reinsurance markets and could make insurance 
scarcer and more expensive in the United States. 



(236) 



237 
Revenue Effect 

[Fiscal years, billions of dollars] 



Proposal 


1988 


1989 


1990 


1988-90 


Treatment of certain 
insurance syndicates... 


(^) 


(^) 


(') 


0.1 



Gain of less than $50 million. 



g. Capitalize agents' commissions 
Present Law 

Under present law, a life insurance company generally computes 
its tax liability by using the accrual method of accounting, or (to 
the extent permitted in regulations) by using a combination of the 
accrual method with another method (but not the cash method). 
All computations, however, to the extent not inconsistent with Fed- 
eral tax accounting rules, are made in a manner consistent with 
the manner required for accounting on the annual statement ap- 
proved by the National Association of Insurance Commissioners 
("NAIC"). Consistent with the annual statement reporting require- 
ments, life insurance companies generally deduct agents' commis- 
sions when paid. 

When premiums are initially included in income, the company 
also deducts an amount for the concomitant increase in reserves, 
reflecting the liability to pay death benefits under the policies for 
which the premiums were paid. Net increases in reserves for the 
year are treated as deductible, and net decreases in reserves are 
treated as gross income. The deduction for increases in reserves ef- 
fects a deferral of a portion of the premium income the company 
receives. 

Possible Proposal 

Agents' commissions paid by life insurance companies as an ex- 
pense of earning premium income could be capitalized and amor- 
tized over the period that the premium income remains deferred 
(for example, over the period of coverage under the policy). Alter- 
natively, the amortization period could be a fixed period of years 
(e.g., 20 years), for ease of administration. 

Pros and Cons 
Arguments for the proposal 

1. Because a portion of a life insurance company's premium 
income is deferred through the reserve deduction, while agents' 
commissions associated with obtaining the premium income are 
currently deducted, there is a mismatching of income and expenses 
under present law. The proposal would limit this mismatching of 
income and expenses and, thus, provide a more accurate measure 
of insurance company income. 

2. Reliance on annual statement methods of accounting for tax 
purposes is inappropriate in this instance, because the annual 
statement is founded on State insurance regulators' concerns for 
insurance company solvency, not on accurate measurement of 
income. 

(238) 



239 

3. Other insurance companies are required to reduce their re- 
serve deductions by a percentage intended to prevent mismatching 
of deferred premium income and currently deductible premium ac- 
quisition expenses. The proposal would make the treatment of 
agent's commissions for life insurance companies more consistent 
with the treatment of premium acquisition expenses by other in- 
surance companies. 

Arguments against the proposal 

1. The proposal would impose an unjustified administrative 
burden on life insurance companies because it may be difficult to 
ascertain the period over which premium income is deferred. 

2. The proposal contravenes Congressional policy, expressed in 
the 1984 reorganization of the provisions for life insurance compa- 
ny taxation, to continue reliance on annual statement methods of 
accounting to the extent they differ from accrual method account- 
ing. The use of the preliminary term method in computing life in- 
surance reserves partially takes into account the mismatching of 
income and expenses that occurs under present law. 

3. Agents' commissions represent a properly accrued liability at 
the time a premium payment is received; it is inappropriate to 
adjust for a perceived mismatching of income and deduction by 
prohibiting the accrual of a properly accrued expense. 

Revenue Effect 

[Fiscal years, billions of dollars] 



Proposal 


1988 


1989 


1990 


1988-90 


Capitalize agents' 
commissions 


0.1 


0.2 


0.3 


0.6 



n 



14. Capital Gains 

a. Like-kind exchanges 

Present Law 

An exchange of property, like a sale, generally is a taxable trans- 
action. However, no gain or loss is recognized if property held for 
productive use in the taxpayer's trade or business, or property held 
for investment purposes, is exchanged solely for property of a like- 
kind that also is to be held for productive use in a trade or business 
or for investment. 

In general, any kind of real estate is treated as of like kind with 
all other real estate. By contrast, different types of personal prop- 
erty (e.g., equipment or vehicles) are not treated as of like kind. 
Certain types of property, such as inventory, stocks and bonds, and 
partnership interests, cannot be used as like-kind property. 

The like-kind standard contrasts with the standard generally ap- 
plying for purposes of providing for nonrecognition of gain upon 
certain involuntary conversions of property (e.g., through destruc- 
tion, theft, seizure, or condemnation). Other than upon a condem- 
nation of real estate (to which the like-kind standard applies), 
present law grants nonrecognition to involuntary conversions only 
if the taxpayer acquires replacement property that is similar or re- 
lated in service or use to the converted property. This standard is i 
significantly narrower than the like-kind standard. For example, 
unimproved and improved real estate are not considered similar or i 
related in service or use. I 

In one case, a court held that an exchange qualified for like-kind j 
treatment even though the property to be exchanged could be des- 
ignated by the transferor for up to 5 years after the transaction 
and even though, under the terms of the transaction, the transfer- 
or ultimately could have received cash rather than like-kind prop- 
erty. The Deficit Reduction Act of 1984 provided that transactions 
generally could qualify for nonrecognition treatment only so long 
as the replacement property was identified within 45 days and 
transferred within 180 days of the original transfer. 

Possible Proposals 

1. The list of types of property that cannot be treated as like-kind 
property for purposes of the nonrecognition rules could be expand- 
ed to include real estate. 

2. The like-kind standard could be replaced by the standard, gen- 
erally applying for purposes of nonrecognition on involuntary con- 
versions, whereby the property that is acquired must be "similar or 
related in service or use" to the property that is transferred. 

3. The like-kind exchange nonrecognition provision could be 
made applicable only to simultaneous transfers. 

(240) 



241 

Pros and Cons 
Arguments for the proposals 

1. Nonrecognition on like-kind exchanges is justified only when 
the taxpayer remains in a similar economic position after the ex- 
change. The like-kind standard as applied to real estate is too 
broad and flexible to ensure that a taxpayer's economic position is 
not significantly altered by the exchange, giving investors a tax 
preference in comparison to investors in productive assets such as 
stocks and equipment. 

2. The like-kind standard for comparing the property transferred 
with the property received should be no broader than the general 
standard applying for involuntary conversions. Involuntary conver- 
sions are not a tool for tax planning, and give rise to stronger 
equity reasons for not taxing gain than voluntary exchanges. 

3. Recognition of gain is appropriate in nonsimultaneous trans- 
fers, where the transferor in effect beneficially receives cash and 
subsequently buys new property. 

Arguments against the proposals 

1. Exchanges of like-kind property, including real estate, should 
not give rise to immediate tax liability, since the taxpayer has not 
received cash or sufficiently changed the form of his investment. 

2. Allowing nonrecognition of gain on like-kind exchanges in- 
creases the mobility of capital, by permitting taxpayers to ex- 
change appreciated assets without incurring tax liability. 

3. Allowing nonsimultaneous transfers to qualify for nonrecogni- 
ton treatment makes it easier for taxpayers to avoid recognition of 
gain, since such transactions create increased flexibility where the 
transferor cannot immediately locate suitable replacement proper- 
ty, or where the parties have difficulty in transferring title simul- 
taneously. 



b. Individual capital gains 

Present Law 

Under present law, capital gain net income is taxed the same as 
ordinary income, beginning in 1988. 

Possible Proposal 

The maximum rate on individual net capital gains could be 15 
percent. 

Pros and Cons 
Argument for the proposal 

Reduction of the capital gains rate will promote economic growth 
and risky investments. 

Argument against the proposal 

Reduction of the capital gains rate will increase tax complexity 
and will cause upper-income taxpayers to pay less income tax. 

(242) 



15. Alternative Minimum Tax 

Present Law 

Under present law, taxpayers are subject to an alternative mini- 
mum tax which is payable, in addition to all other tax liabilities, to 
the extent it exceeds the taxpayer's regular tax. The tax is imposed 
at a flat rate of 21 percent (20 percent in the case of a corporation) 
on alternative minimum taxable income in excess of an exemption 
amount. Alternative minimum taxable income generally is the tax- 
payer's taxable income, as increased or decreased by certain adjust- 
ments and preferences. The foreign tax credit and, to a limited 
extent in the case of corporations, the investment tax credit are al- 
lowed against the minimum tax. 

Adjustments and preferences are provided for accelerated depre- 
ciation, mining exploration and development costs, certain long- 
term contracts, pollution control facilities, installment sales, circu- 
lation and research and experimental expenditures of individuals, 
miscellaneous itemized deductions, itemized deductions for State 
and local taxes, Merchant Marine Capital Construction Funds, spe- 
cial insurance deductions, percentage depletion, excess intangible 
drilling costs over 65 percent of oil and gas income, incentive stock 
options, bad debt reserves, tax-exempt interest on certain newly 
issued private activity bonds, appreciated property charitable de- 
ductions, farm losses, and passive losses. 

In addition, for 1987 through 1989, one-half of the excess of pre- 
tax book income of a corporation over other alternative minimum 
taxable income is a preference. For taxable years beginning after 
1989, three-fourths of the excess of adjusted current earnings over 
other alternative minimum taxable income is a preference. 

Possible Proposals 

1. The minimum tax rate for individuals could be increased to a 
rate greater then 21%. 

2. The minimum tax rate for corporations could be increased to a 
rate greater than 20%. 

3. Additional preferences could be added to the minimum tax. 
Such preferences could include inside buildup on life insurance and 
annuities, tax-exempt interest on additional bonds, all excess intan- 
gible drilling costs, excludable fringe benefits, nonforfeitable pen- 
sion benefits, circulation expenses and research expenditures of 
corporations, life insurance company reserves, exclusion of income 
of foreign sales corporations, allocation of research and experimen- 
tal expenses between U.S. and foreign income, LIFO inventory, ex- 
cludable interest on loans to ESOPs, excludable gain on sales to 
ESOPs, and provisions providing for nonrecognition of gain. 

(243) 



244 

4. Unrelated businesses could be prohibited from consolidating or 
the passive loss rules could be made applicable to all corporations 
for purposes of the minimum tax. 

5. 100 percent of the excess of book income over other alternative 
minimum taxable income (until 1990) and 100 percent of the excess 
of adjusted current earnings over other alternative minimum tax- 
able income (after 1989) could be made preferences. 

6. The book income preference could be measured by making ad- 
justments for material events in the same year or years for com- 
puting book income as for computing alternative minimum taxable 
income. This adjustment could apply to events occurring in taxable 
years beginning after 1984. 

Pros and Cons 

Arguments for the proposals 

1. In periods of budget stringency, the minimum amount that 
each higher income individual and each corporation should pay 
should be increased. 

2. An across-the board rate change (or surtax) would reduce the 
benefits of tax preferences without the necessity to revisit each 
preference and decide the relative merits of different preferences. 

3. Some persons would feel that the tax system is fairer if the 
minimum tax were strengthened. 

4. Adding new preferences would improve the measurement of 
economic income. 

5. Limiting consolidation could discourage tax-motivated corpo- 
rate mergers. 

Arguments against the proposals 

1. The tax preferences which are subject to the minimum tax are 
allowed for regular tax purposes to accomplish some social or eco- 
nomic purpose. These goals would be undermined by an increase in 
the minimum tax rate, or an expansion of the preferences. 

2. An increase in the rates would cause more taxpayers to be 
subject to the minimum tax and therefore would add complexity to 
the law. 

3. In the case of the individual minimum tax, an increase in the 
rate might be viewed as a device for cutting back on the deductibil- 
ity of State and local taxes. 

4. Adding new preferences, or limiting consolidation among lines 
of businesses, could cause substantial additional complexity in 
some cases. 



245 
Revenue Effect 

[Fiscal years, billions of dollars] 
Proposal 1988 1989 

Increase individual 

rate to 25 percent 0.8 3.7 

Increase corporate rate 

to 21 percent 0.3 0.5 

Add more preferences 

(including certain 

fringe benefits, 

inside buildup on life 

insurance, 

nonforfeitable 

pension benefits) 0.1 0.5 



1990 



1988-90 



2.7 
0.5 



7.1 
1.3 



0.3 



0.9 



16. Natural Resources 

a. Oil and gas working interests 

j 
Present Law a 

Present law, as amended by the 1986 Act, provides that deduc- 
tions from passive trade or business activities, to the extent they 
exceed income from all such passive activities (exclusive of portfo- 
lio income), generally may not be deducted against other income. 
Suspended losses are carried forward and treated as deductions 
from passive activities in the next year. Suspended losses are al- 
lowed in full when the taxpayer disposes of his entire interest in , 
the activity to an unrelated party in a transaction in which all re- 
alized gain or loss is recognized. The provision applies to individ- 
uals, estates, trusts, and personal service corporations. A special 
rule limits the use of passive activity losses and credits against 
portfolio income in the case of closely held corporations. 

An activity generally is treated as passive if the taxpayer does 
not materially participate in it. A taxpayer is treated as materially 
participating in an activity only if the taxpayer is involved in the 
operations of the activity on a basis which is regular, continuous, 
and substantial. 

Under present law, a working interest in an oil or gas property is 
not treated as a passive activity, whether or not the taxpayer mate- 
rially participates. A working interest for purposes of this provision 
means an interest with respect to an oil or gas property that is bur- 
dened with the cost of development and operation of the property 
and with respect to which the taxpayer's form of ownership does 
not limit the liability of the taxpayer. 

Possible Proposal 

The rule applicable to oil and gas working interests could be re- 
pealed. Thus, a working interest in an oil or gas property with re- 
spect to which the taxpayer does not materially participate would 
be treated as a passive activity. 

Pros and Cons 

Arguments for the proposal 

1. All activities in which the taxpayer does not materially par- 
ticipate should be treated the same, and losses from such activities 
should be subject to the loss limitations enacted in 1986. 

2. The passive loss exception favors the oil and gas industry rela- 
tive to other sectors of the economy. This may cause an inefficient 
allocation of resources. 

(246) 



247 

Arguments against the proposal 

1,: Granting tax benefits to investors in oil and gas working inter- 
ests that are not owned through an entity limiting liability is con- 
sistent with national energy security policy. 

2. It is difficult for oil and gas drillers to raise capital through 
the debt market or bank loans due to the volatility of oil and gas 
prices. The working interest exception encourages needed equity 
capital to flow into the industry. 

Revenue Effect 

[Fiscal years, billions of dollars] 
Proposal 1988 1989 1990 1988-90 

Oil and gas working interests 0.1 0.3 0.3 0.7 



74-267 0-87-9 



b. Percentage depletion 

Present Law 

Under present law, persons owning economic interests in mines, 
oil and gas wells, other natural deposits, and timber may deduct an 
allowance for depletion in computing taxable income. For most nat- 
ural resources other than timber, taxpayers must use the greater 
of either percentage or cost depletion. 

Under cost depletion, the taxpayer deducts his basis in the prop- 
erty over the life of the mineral resource. The percentage depletion 
allowance is calculated as a fixed, statutory percentage of the tax- 
payer's gross income from the mineral property (but not in excess 
of 50 percent of taxable income from the property). The statutory 
percentage varies from 5 to 22 percent of gross income, depending 
upon the mineral. 

The allowance for cost depletion may not result in recovery of 
more than the taxpayer's basis in the property. On the other hand, 
the percentage depletion allowance is computed without regard to 
the taxpayer's basis in the property and may, therefore, exceed the 
taxpayer's cost basis in the property. (In the case of corporations, 
the percentage depletion deduction for coal and iron ore is reduced 
by 20 percent of the deduction otherwise allowable in excess of the 
corporation's adjusted basis in the property.) 

In the case of oil and gas wells, the allowance for percentage de- 
pletion is computed only with respect to up to 1000 barrels a day of 
oil or gas production by independent producers or royalty owners. 
The percentage depletion rate for independent producers and royal- 
ty owners is 15 percent. Persons who are retailers or refiners are 
excluded from independent producer status and are, therefore, not 
allowed percentage depletion with respect to oil and gas produc- 
tion. Percentage depletion on all oil and gas wells is limited to 65 
percent of the taxpayer's taxable income. 

Percentage depletion in excess of adjusted basis is an item of tax 
preference for purposes of the alternative minimum tax. 

Possible Proposals 

1. The Treasury Department's 1984 tax reform study proposed re- 
pealing percentage depletion with respect to the production of all 
minerals. 

2. The President's 1985 Tax Reform Proposal proposed repealing 
percentage depletion for all minerals except for oil and gas stripper 
wells owned by independent producers. 

(248) 



249 

Pros and Cons 
Arguments for the proposals 

1. Percentage depletion allows depletion deductions in excess of 
cost depletion and in excess of the property's adjusted basis and 
therefore improperly measures economic income. 

2. Percentage depletion subsidizes production in the industries 
covered by that allowance, and thereby favors investment in those 
industries. 

3. Because percentage depletion subsidizes domestic production, 
it encourages higher consumption of scarce domestic minerals. 

''Arguments against the proposals 

1. Some mineral industries are currently in a depressed condi- 
tion. Repeal of pecentage depletion would further reduce their 
return on investment. 

2. Repeal of percentage depletion could cause some marginal 
wells and mines to be closed in cases where the operator otherwise 
would have made repairs or other investments to continue produc- 
tion. Once a well or mine is closed, reopening may not be economi- 
cally justified unless the price of the resource rises much higher 
than previous levels. 

3. Natural resources industries require high-risk investments 
which should be encouraged by the tax system for reasons of na- 
tional security. 

Revenue Effect 

[Fiscal years, billions of dollars] 
Proposal 1988 1989 1990 1988-90 

Repeal percentage depletion on: 

Oil and natural gas: all wells 0.3 0.5 0.5 1.4 

Oil and natural gas: all wells other 
than stripper wells owned by in- 
dependent producers 0.2 0.4 0.4 1.0 

Other minerals 0.3 0.6 0.6 1.5 



c. Intangible drilling costs 

Present Law 

Under present law, an operator who pays or incurs intangible 
drilling or development costs ("IDCs") in the development of a do- 
mestic oil or gas property or certain geothermal wells, may elect 
either to expense or capitalize such amounts. For this purpose, 
IDCs include all expenditures by an operator for wages, fuel, re- 
pairs, hauling, etc., in connection with the excavating, grading, 
drilling, shooting, or cleaning of wells, and all other expenses inci- 
dent to and necessary for the drilling of wells and the preparation 
of wells for the production of oil and gas (or geothermal energy). 
Generally, IDCs do not include expenses for items which have a 
salvage value (such as pipes and casings), or items which are part 
of the acquisition price of an interest in the property. 

Generally, if IDCs are not expensed, but are capitalized, they can 
be recovered through depletion or depreciation, as appropriate. 
However, if IDCs are capitalized and are paid or incurred with re- 
spect to a nonproductive well ("dry-hole"), they may be deducted, 
at the election of the operator, as an ordinary loss in the taxable 
year in which the dry hole is completed. In the case of an integrat- 
ed oil company, 30 percent of the IDCs on productive wells must be 
capitalized and amortized over a 60-month period. 

IDCs in excess of the amount which would have been currently 
deductible if IDCs had been capitalized and recovered over a 10- 
year period are an item of tax preference for purposes of the alter- 
native minimum tax, to the extent that this difference exceeds 65 
percent of net oil and gas income. 

Possible Proposals 

1. The Treasury Department's 1984 tax reform study proposed to 
repeal the election to expense IDCs. Recovery of such expenses 
would have been required to be made through depletion or depre- 
ciation deductions. 

2. A repeal of the election to expense IDCs could apply only to 
integrated oil companies. 

3. The IDC expensing election could be repealed and replaced by 
a requirement that IDCs be capitalized and amortized over some 
statutory period (e.g., 5 or 10 years). 

Pros and Cons 
Arguments for the proposals 

1. The election to expense IDCs is a departure from general 
income tax principles which require that costs associated with the 
production of inventory-type property be capitalized. 

(250) 



251 

2, Expensing of IDCs favors investment in the oil and gas indus- 
try relative to other sectors of the economy. This may cause an in- 
efficient allocation of capital. 

Arguments against the proposals 

1. Expenditures for research and development are expensed 
under present law. Exploratory drilling is similar to research due 
to the high level of risk. This may justify comparable treatment. 

2. Most new oil wells are drilled by independent drillers who 
depend upon this deduction to maintain their cash flow. Drilling 
activity has declined precipitously over the past 18 months. If the 
expensing option is removed, the number of wells drilled will be 
further reduced. 

Revenue Effect 

[Fiscal years, billions of dollars] 
Proposal 1988 1989 1990 1988-90 

Repeal election to expense intangible 
drilling costs for: 

(1) All producers 1.0 1.6 1.4 3.9 

(2) Integrated producers 0.5 0.9 0.8 2.2 



17. Compliance i 

a. Estimated taxes 

Present Law 

Under present law, individuals owing income tax who do not 
make estimated tax payments are generally subject to a penalty. In 
order to avoid the penalty, individuals must make quarterly esti- 
mated tax payments that equal at least the lesser of 100 percent of 
last year's tax liability or 90 percent of the current year's tax li- 
ability. Amounts withheld from wages are considered to be estimat- 
ed tax payments. 

The Tax Reform Act of 1986 increased to 90 percent (from 80 per- 
cent) the proportion of the current year's tax liability that taxpay- 
ers must make as estimated tax payments in order to avoid the es- 
timated tax penalty. This increase became effective with respect to 
taxable years beginning after December 31, 1986. 

Possible Proposals 

1. The increase in the proportion of the current year's tax liabil- 
ity that taxpayers must make as estimated tax payments could be 
delayed for one year. 

2. The safe harbor of 100 percent of the previous year's liability 
could be made inapplicable to sizeable increases in income. 

Pros and Cons 
Arguments for the proposals 

1. The current year (1987) is the first year that taxpayers are 
subject to most of the provisions in the Tax Reform Act of 1986. 
Also, many taxpayers were confused by the initial Form W-4 issued 
by the IRS. Delaying the increase in the estimated tax threshold 
could be beneficial to taxpayers uncertain of their ultimate tax li- 
ability due to these events. 

2. Taxpayers who know that their current year's income has in- 
creased substantially over that of the past year should not be al- 
lowed to utilize the estimated tax payment structure as a mecha- 
nism for tax deferral. 

Arguments against the proposals 

1. The proposal to delay the increase in the estimated tax thresh- 
old does not raise additional revenue new to the Federal Govern- 
ment; it shifts revenue from FY 1987 into FY 1988. 

2. Taxpayers need the certainty provided by a mechanical esti- 
mated tax safe harbor; altering the 100 percent safe harbor would 
eliminate certainty from that test. 

(252) 



253 
Revenue Effect 

[Fiscal years, billions of dollars] 



Proposal 1988 1989 1990 1988-90 

(1) Delay increase in estimated tax 

threshold 1.4 1.4 

(2) Modify previous year safe harbor 

(estimated tax) 0.3 0.1 0.1 0.5 



b. IRS funding 

Present Law 

Increasing IRS funding in a number of areas could have a direct 
impact on Federal revenues. For example, increasing the number 
of employees in Examination and Collection can increase Federal 
revenues, so long as the increases are not greater than the ability 
of the IRS to train and absorb the new employees and so long as 
the point where increased receipts from greater compliance equal 
the increase in expenditures relating to the new employees has not 
been reached. 

Increasing IRS funding in other areas may have an indirect (and 
unmeasurable) impact on Federal revenues. For example, improv- 
ing and expanding taxpayer assistance and upgrading the IRS tele- 
phone and mail response system to taxpayers' inquiries could sig- 
nificantly, albeit indirectly, improve overall levels of taxpayer com- 
pliance with the income tax laws. 

Possible Proposal 

1. It would be possible to increase the level of IRS funding in a 
number of specific areas. The increases could be targeted to im- 
proving taxpayer compliance. 

Pros and Cons 
Arguments for the proposal 

1. Increasing taxpayer compliance can increase Federal revenues 
without increasing tax rates or otherwise altering substantive pro- 
visions of the tax law. 

Arguments against the proposal 

1. Increases in IRS funding may not be within the jurisdiction of 
the Committee on Ways and Means. 

(254) 



c. Withholding 

Present Law 

Under present law, wages and many pension payments are sub- 
ject to income tax withholding. Most other payments are not gener- 
ally subject to withholding. 

Possible Proposals 

1. Withholding could be imposed on income from stocks, bonds, 
and royalties. 

2. Withholding could be imposed on payments to independent 
contractors, parallel to withholding on wages paid to employees. 

Pros and Cons 
Arguments for the proposals 

1. Withholding increases compliance with the tax laws. 

2. The level of tax compliance by independent contractors is one 
of the lowest rates of all sectors of the economy. 

3. There is no tax policy justification for making some forms of 
income subject to withholding and other forms of income not sub- 
ject to withholding. 

4. It is difficult to distinguish the employment status of many in- 
dependent contractors from that of employees. 

Arguments against the proposals 

1. Withholding imposes a substantial administrative burden on 
those required to do the withholding. 

2. Withholding on payments to independent contractors would 
apply to the gross payments to the independent contractors, and 
therefore would not necessarily approximate ultimate tax liability, 
which depends on net income after expenses. 

Revenue Effect 

[Fiscal years, billions of dollars] 



Proposal 1988 1989 1990 1988-90 



(1) 10-percent withholding on stocks 

and bonds ^ 1.9 0.3 0.3 2.5 

(2) 10-percent withholding on inde- 
pendent contractors 0.6 0.6 0.7 2.0 



(255) 



d. Collection of debts owed to Federal agencies 
Present Law 

Federal agencies can notify IRS that a person owes a past due, 
legally-enforceable debt to the Federal agency. The IRS then must 
reduce the amount of any tax refund due the person by the amount 
of the debt and pay that amount to the agency. This program ex- 
pires on January 1, 1988. Under IRS regulations, the program only 
affects refunds due individuals, not corporations. Also, the program 
applies to debts owed to a limited number of Federal agencies. 

Possible Proposals 

1. Extend the program for two years, either for only those agen- 
cies currently participating or for all Federal agencies. 

2. Expand the program to cover corporate, as well as individual, 
debts owed to Federal agencies. 

Pros and Cons 
Arguments for the proposals 

1. The Federal Government should use every means available to 
collect debts owed to it. The refund offset program provides a 
mechanism to collect debts owed to Federal agencies that the agen- 
cies have been unable to collect themselves. 

Arguments against the proposals 

1. Taxpayers' confidence in the tax system may be eroded when 
the tax system is used for non-tax purposes. 

2. The compliance level of taxpayers whose refunds are offset 
may decrease in years following the offset, which would decrease 
Federal revenues. 

3. These proposals could distract the IRS from its primary goal, 
which is administering and enforcing the Federal tax laws. 

4. Many of these debts could be collected by better enforcement 
and collection activities by the agencies actually owed the money. 

Revenue Effect 

[Fiscal years, billions of dollars] 
Proposal 1988 1989 1990 1988-90 

Extend debt collection 0.1 (i) (i) 0.2 

^ Gain of less than $50 million. 

(256) 



e. Escheat of refunds 

Present Law 

No provision of the Code requires that unclaimed Federal tax re- 
funds escheat (revert) to the Federal Government. Some State 
courts have held that unclaimed Federal tax refunds escheat to the 
State. 

Possible Proposal 

The Code could be amended to require that unclaimed Federal 
tax refunds escheat to the Federal Government. 

Pros and Cons 
Arguments for the proposal 

1. Because the refunds relate to Federal tax obligations, they are 
more related to the Federal Government than to the States. 

Arguments against the proposals 

1. Escheat has generally been utilized by the States, rather than 
the Federal Government. 

Revenue Effect 

[Fiscal years, billions of dollars] 
Proposal 1988 1989 1990 1988-90 

Escheat of refunds {^) (^) (^) (') 

^ Gain of less than $50 million. 

(257) 



E. Gift, Estate, and Generation-Skipping Transfer Taxes 
1. Rates and Unified Credit 

Present Law 

A gift tax is imposed on transfers by gift during life and an 
estate tax is imposed on transfers at death. The gift and estate 
taxes are a unified transfer tax system in that one progressive tax 
is imposed on the cumulative transfers during the lifetime and at 
death. 

For 1987, the gift and estate tax rates begin at 18 percent on the 
first $10,000 of transfers and reach 55 percent on transfers over $3 
million. For transfers after 1987, the top gift and estate tax rate is 
scheduled to decline to 50 percent for transfers over $2.5 million.^ 

In addition, the cumulative amount of any gift or estate taxes is 
reduced by a unified credit. The gift or estate tax is first computed 
without any exemption and then the unified credit is subtracted to 
determine the amount of gift or estate tax payable before the al- 
lowance of other credits. The present amount of the credit is 
$192,800.2 The unified credit of $192,800 effectively exempts the 
first $600,000 of transfers from gift and estate tax. 

In addition, a generation-skipping transfer tax is imposed on 
transfers from one generation to another that otherwise would not 
be subject to a gift or estate tax. The generation-skipping transfer 
tax has a flat rate equal to the highest gift and estate tax rate. 
Each transferor of a generation-skipping arrangement is allowed a 
$1 million exemption. 

Possible Proposals 
Gift and estate tax rates 

1. Retain the gift and estate tax rates applicable in 1987 for 
transfers made after 1987. 

2. Increase the maximum gift and estate tax rates for some 
higher level (e.g., 65 percent on transfers in excess of $10 million). 

3. Provide a single flat rate for the gift and estate tax, e.g., 50 
percent if the maximum rate of present law is retained. The Task 
Force on Transfer Tax Restructuring of the Section of Taxation of 



' Prior to the Tax Reform Act of 1976, the top estate tax was 77 percent on transfers over $10 
milhon. The 1976 Act reduced the top gift and estate tax rate to 70 percent on transfers over $5 
million. The Economic Recovery Tax Act of 1981 reduced the maximum gift and estate tax rate 
over a four year period to 50 percent for transfers after 1984. The Deficit Reduction Act of 1984 
postponed the reduction in the top gift and estate tax rate from 55 percent to 50 percent for 
three years (i.e., until transfers made after 1987). 

2 Prior to the 1976 Act, there was a $30,000 lifetime exemption for gift tax purposes and a 
$60,000 exemption for estate tax purposes. The 1976 Act converted the prior gift and estate tax 
exemptions into a unified credit that increased from $30,000 to $47,000 over the period 1977 to 
1981. The 1981 Act increased the unified credit from $47,000 in 1981 to $192,800 over the period 
1981 to 1986. 

(258) 



259 

the American Bar Association has recommended a single flat rate 
for gift and estate taxes. 

4. Impose a 2-percent estate tax on the assets less liabilities held 
at death with no unified credit allowed. 

Unified credit 

1. Reduce the amount of the unified credit. For example, the uni- 
fied credit could be set at its 1982 level (i.e., $62,800 or an exemp- 
tion equivalent of $225,000) and indexed for subsequent inflation. 

2. Phase-out the unified credit for large transfers (e.g., transfers 
in excess of $10 million). 

Pros and Cons 
Arguments for the proposals 
Transfer tax rates 

1. The scheduled reductions in the maximum Federal gift and 
estate tax rates were enacted in 1981 pursuant to a broad tax re- 
duction measure. They are inappropriate in a time of budgetary re- 
straint. 

2. Increasing the maximum gift and estate tax rates (or retaining 
present gift and estate tax rates) will raise taxes only for the 
wealthy. The gift and estate taxes are necessary to an overall pro- 
gressive rate system and increasing the maximum rate of gift and 
estate taxes insures a progressive tax structure. 

3. With the present level of the unified credit, the gift and estate 
tax rates effectively begin with a rate of 37 percent on transfers in 
excess of $600,000 and reach a maximum rate of 55 percent on 
transfers in excess of $3 million (50 percent on transfers in excess 
of $2.5 million after 1987). Thus, the gift and estate tax rates are 
nearly flat. Nonetheless, much estate planning arises from at- 
tempts to utilize fully the lower rate brackets for estates of both 
spouses. 

Unified credit 

The increase in the unified credit enacted in 1981 was intended 
to offset the effects of inflation on property values. Since the rate 
of inflation has been significantly lower than anticipated, much of 
this increase has proved unnecessary. Lowering the unified credit 
to the 1982 level (adjusted for inflation) would still leave the great 
majority of estates exempt from Federal estate tax. 

Arguments against the proposals 

Transfer tax rates 

1. Retention of the scheduled reduction in the maximum rate of 
gift and estate taxes is consistent with the general reduction in 
income tax rates. 

2. A higher maximum estate tax rate creates hardship because 
cash needs are typically high at death. 

Unified credit 

1. Reduction of the unified credit will subject many more estates 
to Federal estate tax. Since real estate and closely-held businesses 



260 

often appreciate more than other assets, the estates of many home- 
owners and owners of closely held businesses would be subject to 
estate tax. 

2. Death is an inopportune time to impose a tax, because needs 
for cash are typically high at that time. Thus, the estate tax should 
not apply to small and mid-sized estates (i.e., those with assets 
valued at $600,000 or less), which are most likely to have an acute 
need for cash. 

Revenue Effect 

[Fiscal years, billions of dollars] 
Proposal 1988 1989 1990 1988-90 

Rates and unified credits: 



a. 2% death tax with no credit.... 

b. Freeze 1987 rates 


(^) 


0.8 
0.2 

0.1 


1.0 
0.2 

0.2 


1.8 
0.5 f 


c. 60% top rate above $10 mil- 
lion 


0.3 


^ Gain of less than $50 million. 











2. Repeal of the "Stepped-up Basis" Rule 

Present Law 

The cost or basis of property acquired from or passing from a de- 
cedent is its fair market value at the date of death (or alternate 
valuation date if that date is elected for estate tax purposes). The 
basis of property acquired from or passing from the decedent is 
often referred to as a "stepped-up basis." Under the stepped-up 
basis rule, appreciation after the decedent acquired the property is 
not subject to income tax. 

On the other hand, in the case of property acquired by gift, the 
donee's basis generally is the same as the donor's. The basis of 
property acquired by gift is often referred to as a "carryover basis." 

The Tax Reform Act of 1986 repealed the tax favored treatment 
of capital gains. 

Possible Proposals 

1. An income tax could be imposed on the net appreciation in 
property passing from a decedent at his death. In order to exempt 
relatively small estates from such an appreciation tax, that tax 
could be offset by an exemption or any unused portion of the dece- 
dent's unified credit. Property passing to a surviving spouse or to 
charity would not be subject to the appreciation tax, but would re- 
ceive a carryover basis similar to that provided for transfers by 
gift. As under present law, the basis of all other property would be 
its fair market value at the date of death. A similar proposal was 
described in the report of the Task Force on Transfer Tax Restruc- 
turing of the Section of Taxation of the American Bar Association. 

2. Alternatively, it would be possible to achieve a similar result 
by permitting a partial credit against the estate tax for the dece- 
dent's basis in the property includible in the gross estate. In order 
to raise revenue, the enactment of the credit would be coupled with 
increased estate tax rates. 

3. The basis of an asset acquired from a decedent could be made 
equal to the decedent's basis in the asset (i.e., a carryover basis). 

Pros and Cons 
Argument for the proposals 

1. Adoption of any of the proposals would end the "lock-in" effect 
of present law under which taxpayers retain assets during their 
lifetimes in order to obtain forgiveness of the tax on the gain at 
death through the "stepped-up" basis rule. This "lock-in" effect has 
been exacerbated by the 1986 Act changes. The "lock-in" effect im- 
pedes the efficient operation of the capital markets. 

2. Under these proposals, the overall taxes imposed on property 
would be roughly the same regardless of whether the property is 

(261) 



262 

sold before death by the decedent, sold after death by his estate or 
heir, or sold by a donee to whom the property had been given prior 
to death. 

3. Under the Canadian income tax, both death and gift are treat- 
ed as realization events — a system which generally is viewed as 
workable. 

Arguments against the proposals 

1. In order to comply with the rule taxing appreciation at death 
(or carryover basis), individuals would be required to retain written 
records for all their assets. Many taxpayers do not keep such 
records. The Congress should not impose such an extensive record- 
keeping burden on the public. 

2. Even where individuals keep adequate records of the bases of 
their assets, the executor or spouse .must locate those records. 
Moreover, where decedent does nokkeep such records and the are 
not otherwise available, executors and heirs will have difficulty 
complying with an appreciation tax. 

3. Any tax on appreciation of assets held at death (or a carryover 
basis for such assets) would increase the overall taxes on assets 
passing from one generation to another. 

Revenue Effect 

[Fiscal years, billions of dollars] 
Proposal 1988 1989 1990 1988-90 

Repeal of "stepped up" basis rule: 

Capital gains at death (*) 4.9 5.3 10.2 

Carryover basis 0) 0.5 1.2 1.7 

^ Gain of less than $50 million. 



3. Taxation of Life Insurance 

Present Law 

The proceeds of a life insurance policy on the decedent's life are 
includible in the gross estate of the decedent if either (1) the pro- 
ceeds are receivable by the executor or administrator or payable to 
the estate or (2) the decedent at his death (or any time within three 
years of his death) possessed any "incidents of ownership" in the 
policy. Incidents of ownership include the power to change the ben- 
eficiary of the policy, to assign the policy, to borrow against its 
cash surrender value, and to surrender or cancel it. 

Possible Proposal 

Include in the gross estate the proceeds of any insurance policy 
payable, directly or indirectly, to a relative of the decedent. A similar 
proposal was described in the report of the Task Force on Transfer 
Tax Restructuring of the Section of Taxation of the American Bar 
Association. 

Pros and Cons 
Arguments for the proposal 

1. Under present law, an individual may take out a life insur- 
ance policy, irrevocably designate beneficiaries of the policy, and 
transfer all incidents of ownership to another person. In that situa- 
tion, the proceeds of the life insurance policy are not includible in 
the decedent's gross estate even if the decedent pays all policy pre- 
miums. Such an arrangement effectively transfers property at 
death while avoiding estate tax. 

2. Life insurance is inherently a death-time transfer. Adoption of 
the proposal would ensure that all transfers at death are subject to 
estate tax. The requirement that the proceeds be paid directly or 
indirectly to a relative of the decedent ensures that the proposal 
would not result in estate taxes being imposed upon "key man" in- 
surance purchased by the individual's employer or partners. 

Arguments against the proposal 

1. Life insurance often has a significant investment element 
which should be taxed like other investments. Consequently, life 
insurance should be includible in the gross estate only where the 
decedent retained interest in, or control over, the investment at his 
death. 

2. The transfer of the incidents of ownership and the payment of 
insurance premiums are subject to the gift tax and, consequently, 
the present tax treatment of life insurance does not permit improp- 
er avoidance of transfer taxes. 

(263) 
74-267 0-87-10 



264 
Revenue Effect 

[Fiscal years, billions of dollars] 



Proposal 1988 1989 1990 1988-90 

Life insurance inclusion (^) 0.3 0.4 0.7 

1 Gain of less than $50 million. 



4. Valuation of Property: Estate Freezes and Minority Discounts 

Present Law 
In general 

The value of property includible in a gross estate is its fair 
market value at the date of the decedent's death (or on the alter- 
nate valuation date if the executor so elects). The fair market value 
is the price at which the property would change hands between a 
willing buyer and a willing seller, neither being under any compul- 
sion to buy or to sell and both having reasonable knowledge of rele- 
vant facts. 

Where actual sales prices and bona fide bid and asked prices are 
lacking, the fair market value of stock is determined by looking to 
various factors, including the company's net worth, prospective 
earning power and dividend-paying capacity, the goodwill of the 
business, the economic outlook in the particular industry, the com- 
pany's position in the industry and its management, the degree of 
control of the business represented by the block of stock to be 
valued, and the values of securities of corporations engaged in the 
same or similar lines of businesses. 

Valuation freezing techniques 

Where an individual transfers a remainder interest in property 
but retains the income from that property for his life, his gross 
estate includes the full value of the property. An individual may, 
however, exclude from his gross estate the value of common stock 
transferred to others, even though he retains preferred stock in 
that corporation with the right to most dividends. See Estate of 
John G. Boykin, 53 T.C.M. (CCH) 345 (1987). A person also may ex- 
clude from her estate the value of an option to purchase property 
owned by her, despite her enjoyment of the property prior to the 
exercise of the option. See Dorn v. United States, 59 A.F.T.R. 2d 
H 148,875 (W.D. Pa. 1986). 

Estate planners use the above rules to "freeze" the value of prop- 
erty so that appreciation in the estate's assets accrues to the 
owners' children and is thereby excluded from the gift and estate 
tax base. One method is to recapitalize a closely-held corporation to 
have both voting preferred and common stock outstanding. The par 
value of the preferred stock is set at the estimated value of the cor- 
poration at that time. The owners give the common stock to their 
children and retain the preferred stock themselves. The owners 
claim that since the par value of the preferred stock is set at the 
estimated value of the corporation, the common stock has little 
value and, consequently, there is little or no gift tax owed. At the 
owners' death the executor values the preferred stock at its par 
value (i.e., the value of the preferred stock is "frozen" at the time 

(265) 



266 

of the recapitalization). Appreciation in the value of common stock 
accrues to the children and passes between generations without 
being subject to gift or estate taxes. 

Another technique for freezing the value of property is for the 
owner to grant to his children a long-term option to purchase the 
property at its current value. Since the option price is the present 
value of the underlying property, the value of the option is claimed 
to be very low. Nonetheless, the option is said to limit the value of 
the property to the option price, allowing the appreciation to avoid 
estate taxation. 

A third method is for an individual to give a spouse an income 
interest in a trust, plus a general power of appointment over a 
specified dollar amount. Under the marital deduction, no gift tax is 
imposed on the gift to the spouse, and the spouse would include 
only the specified amount in her estate. Thus, any appreciation in 
the value of the trust will apparently be taxed in neither spouse's 
estate. See Estate of Alexander v. Commissioner, 82 T.C. 34 (1984), 
aff d No. 84-1600 (4th Cir. April 3, 1985). 

Minority discounts 

Numerous courts recognize that shares of stock in a corporation 
which represent a minority interest are usually worth less than a 
proportionate share of the value of the assets of the corporation. 
See, e.g., Charles W. Ward, 87 T.C. 78 (1986); Estate of Leyman, 40 
T.C. 100 (1963). More recently, a minority discount was allowed 
even where the total shares owned by related persons constituted a 
majority interest. For example, in Estate of Bright v. United States, 
658 F.2d 999 (5th Cir. 1981), the court upheld a minority discount 
on stock transferred to a trust even though the other principal 
shareholder of the corporation was trustee of the trust and father 
of its beneficiary. 

Possible Proposals 
Estate freezes 

The parent's estate could include the full value of property 
which is effectively subject to the retained life interest (i.e., the 
common stock as well as the preferred stock, in the recapitalization 
case, and the value of property as of the date of death, in the 
option case). A life estate with a power of appointment could be 
deemed as not passing to the spouse for purpose of the marital de- 
duction unless the spouse's power is expressed as a fraction or a 
percentage of the estate. 

Minority discounts 

The value of property for Federal gift, estate, and generation- 
skipping transfer tax purposes could be determined by aggregating 
other interests in the property owned by related individuals. Alter- 
natively, the value of stock in closely-held corporations could be 
deemed to be a proportionate share of the corporation's value, for 
those purposes. 



267 

Pros and Cons 
Arguments for the proposals 

1, With the recapitaUzation technique described above, the 
parent effectively retains a Ufe interest in the corporation by keep- 
ing the voting preferred stock. Similarly, the option technique per- 
mits the parent effectively to retain a life estate and transfer a re- 
mainder interest to the children. The estate tax result should not 
differ simply because the economic benefit of the property is re- 
served through preferred stock or non-exercise of the option rather 
than a retained life estate. 

2. A minority discount is proper only where the owners have ad- 
verse interests. Related persons generally share the same interests. 

Arguments against the proposals 

1. Preferred stock and property owned subject to an option pro- 
vide rights significantly different from those of a retained life 
estate. Any abuse of estate freezing techniques lies not in the re- 
tained estate, but in the undervaluation of the gift (of common 
stock or option). 

2. Family members do not always share the same interests and, 
in those situations, disallowing a minority discount results in over- 
valuation of property for gift, estate, and generation-skipping 
transfer tax purposes. 

Revenue Effect 

[Fiscal years, billions of dollars] 



Proposal 


1988 


1989 


1990 


1988-90 


Valuation of property: 

a. Estate freeze 


(1) 


0.6 

0.5 


0.8 
0.5 


1.4 


b. Minority discount 


(1) 


1.1 









1 Gain of less than $50 million. 



5. State Death Tax Credit 

Present Law 

A 100-percent credit is allowed against the Federal estate tax for 
any estate, inheritance, legacy, or succession taxes paid to a State. 
The maximum credit varies with the size of the adjusted taxable 
estate. The maximum credit begins at .8 of 1 percent for assets less 
than $90,000 and increases to 16 percent on assets in excess of 
$10,040,000. 

Possible Proposal 

The credit for State death taxes could be converted into a deduc- 
tion. 

Pros and Cons 
Arguments for the proposal 

1. State death taxes should be treated no more advantageously 
than State income taxes are treated under the Federal income tax. 

2. The existing State death tax credit is a form of revenue shar- 
ing. Many States only impose death taxes that are entirely credita- 
ble against the Federal estate tax. States should not be able to col- 
lect taxes whose burden is to be borne by the Federal Government 
rather than their citizens. 

Arguments against the proposal 

1. The State death tax credit has been in the estate tax law for 
over 50 years. 

2. Converting the credit into a deduction would pressure States 
to repeal or reduce their death taxes, reducing State revenues. 

Revenue Effect 

[Fiscal years, billions of dollars] 
Proposal 1988 1989 1990 1988-90 

Change State tax credit to deduction (^) 0.4 0.5 0.9 

^ Gain of less than $50 million. 



(268) 



6. Definition of Present Interest for Purposes of the Annual Gift 
Tax Exclusion 

Present Law 

Under present law, the first $10,000 of gifts of present interest 
are excluded from Federal gift tax. Several courts have held that a 
donee's power to withdraw annual additions to the trust during the 
year in question gave that donee a present interest in the addi- 
tions. See, e.g., D. Clifford Crummey v. Commissioner, 397 F.2d 82 
(9th Cir. 1968). This result has been upheld even where the donee is 
a minor or lacks knowledge of his right of withdrawal. 

Possible Proposal 

Require that the power of withdrawal last until the death of the 
donee in order to characterize an interest as a present interest. 

Pros and Cons 
Arguments for the proposal 

1. One reason for limiting the annual gift tax exclusion to gifts of 
present interests is to insure that the donee obtains sufficient con- 
trol over the interest so that the gift does not inure to another 
person. A power of withdrawal that is effective for only a very 
short duration does not insure that the gift will not be given to an- 
other beneficiary of the trust. 

2. Use of a short-term power of withdrawal is an important 
means of utilizing the $10,000-per-donee annual gift tax exclusion 
to avoid gift or estate taxes. 

Argument against the proposal 

The limitation of the annual gift tax exclusion to present inter- 
ests was designed to prevent remainder interests in property from 
qualifying for the exclusion. A short-term power of withdrawal 
does not give the donor a remainder interest and can serve legiti- 
mate estate planning purposes. 

Revenue Effect 

[Fiscal years, billions of dollars] 



Proposal 1988 1989 1990 1988-90 



Present interest (gift tax exclusion) ( ^ ) ( ^ ) ( ^ ) 0-1 



^ Gain of less than $50 million. 

(269) 



7. Estate Tax Deduction for Sales to an Employee Stock Owner- 
ship Plan (ESOP) or Worker-Owned Cooperative 

Present Law 

The 1986 Act adopted a special provision allowing partial relief 
from estate taxes through an estate tax deduction for certain sales 
of employer securities to an employee stock ownership plan (ESOP) 
or eligible worker-owned cooperative. Under this special provision, 
the value of the taxable estate of a decedent is determined by de- 
ducting from the value of the gross estate 50 percent of the quali- 
fied proceeds of a qualified sale of employer securities. A qualified 
sale is any sale of employer securities by an executor to an ESOP 
or an eligible worker cooperative. Qualified proceeds is the amount 
received by the estate from the sale of employer securities at any 
time before the due date of the estate tax return, but does not in- 
clude proceeds from sales of securities received by the decedent (1) 
in distribution from a qualified plan or (2) as a transfer pursuant to 
certain options or rights to acquire stock. 

IRS Notice 87-13 (January 5, 1987) provided that the estate tax 
deduction is not available unless (1) the decedent directly owned 
the employer securities immediately before death, and (2) after the 
sale, the employer securities are allocated to plan participants or 
are held for future allocation in connection with a transfer of 
assets from a defined benefit plan or with an exempt loan. 

The deduction is not available for sales of employer securities 
after December 31, 1991. 

Possible Proposals 

1. H.R. 1311 and S. 591 could be adopted. The bills confirm the 
positions taken in IRS Notice 87-13 and further modify the scope of 
the estate tax deduction for sales of stock to an ESOP. 

Under the bills, the availability of the deduction would be par- 
tially curtailed. The maximum allowable deduction would be limit- 
ed to 50 percent of the taxable estate and the maximum reduction 
in tax liability would be limited to $750,000. Proceeds attributable 
to transferred assets would not be taken into account. The deduc- 
tion would be limited to proceeds of sales of qualified employer se- 
curities (1) that are issued by a domestic corporation which has no 
stock outstanding which is readily tradable on an established secu- 
rities market, (2) which are includible in the gross estate of the de- 
cedent, and (3) which would have been includible in the gross 
estate of the decedent if the decedent had died within a specified 
prior period. Certain holding period requirements would apply. An 
excise tax would be imposed if an ESOP or eligible worker-owned 
cooperative disposes of employer securities within three years of ac- 

(270) 



271 

quisition or fails to allocate the securities or the proceeds of the 
disposition to accounts of participants or their beneficiaries. 
2. The deduction could be repealed in its entirety. 

Pros and Cons 
Arguments for the proposals 

1. The bills (H.R. 1311 and S. 591) limit the total revenue loss 
from the special estate tax deduction to the amount originally esti- 
mated and conform the provision to original Congressional intent. 

2. The existence of special tax benefits for transfers of stock to 
an ESOP creates an incentive to maintain an ESOP as a primary 
source of retirement income for employees. The tax laws should not 
create an incentive for an employer to maintain one type of retire- 
ment plan to the exclusion of other types. If an employer experi- 
ences financial difficulty, employees with retirement savings con- 
centrated primarily in employer stock may be subject to a double 
risk of loss. Not only would employees lose their jobs (and employer 
contributions to their retirement plan possibly would be reduced or 
eliminated), but they also may suffer from decreases in the value of 
the securities and the amount of dividends paid thereon. Moreover, 
if a plan is permitted to invest substantially in employer securities, 
a plan fiduciary could be subject to great pressure to time pur- 
chases and sales to improve the market in those securities, whether 
or not the interests of plan participants were adversely affected. 

Arguments against the proposals 

1. Making frequent changes in the ESOP area creates uncertain- 
ty and thereby discourages the use of ESOPs. 

2. The tax incentives historically afforded ESOPs represent an 
attempt to balance tax policy goals encouraging employee stock 
ownership with those encouraging employer-provided retirement 
benefits. The special tax benefits for ESOPs are designed to encour- 
age the sales of stock to ESOPs by shareholders with whom the 
stock ownership has been concentrated, thereby expanding the in- 
dividuals having an ownership interest in an employer. The estate 
tax deduction for sales of securities to an ESOP acconiplishes this 
goal of expanded capital ownership by creating an incentive to 
transfer stock ownership from a decedent's family to the employees 
of the employer whose stock the decedent held. 

Revenue Effect 

' z [Fiscal years, billions of dollars] 



Proposal 1988 1989 1990 1988-90 



Modify estate tax deduction for ESOPs .. 1.8 1.5 2.1 5.4 



F. Tax-Exempt Organizations 

1. Unrelated Business Income Tax on Certain Trade Association 
Income 

Present Law 

The Code imposes a tax on the unrelated business income of oth- 
erwise tax-exempt organizations (sees. 511-514). Although this tax 
generally applies only when an exempt organization receives 
income from an unrelated trade or business, special rules apply to 
certain types of organizations. 

In the case of social clubs (sec. 501(c)(7)), voluntary employee's 
beneficiary associations (sec. 501(c)(9)), and supplemental unemploy- 
ment benefit trusts or group legal service organizations (sees. 
501(e)(17), (e)(20)), the unrelated business income tax (UBIT) applies 
to all income of the organization other than exempt function 
income (see. 512(a)(3)). The latter category of income (exempt func- 
tion income) that is not subject to the UBIT consists of (1) income 
from dues, fees, charges, or similar amounts paid by the organiza- 
tion's members in connection with its exempt purposes; (2) certain 
investment income (or certain other types of income) set aside to be 
used for charitable purposes, or for purposes of paying life, sick, ac- 
cident, or other benefits in the case of section 501(c)(9), 501(c)(17), or 
501(c)(20) organizations; and (3) gain on certain dispositions of 
assets used by the organization in performing its exempt purposes. 

Under this rule, investment income and other nonexempt func- 
tion income earned by social clubs and the specified mutual benefit 
organizations are subject to the UBIT. The legislative history of 
this rule reflects that since such entities are granted exempt status 
so that their members may join together to provide social facilities 
or other personal benefits without tax consequences, the Congress 
concluded that the tax exemption should be limited to membership 
receipts. If investment income could be earned tax-free, the mem- 
bers of such entities would receive personal benefits out of tax-free 
funds. 

Under present law, trade associations and similar organizations 
described in section 501(c)(6) generally are not subject to tax on in- 
terest, dividends, royalties, or certain rents, gains on recognition 
disposition of assets, or other types of income that generally are ex- 
cluded from the UBIT (unless derived from debt-financed property 
or from certain controlled organizations). Thus, trade associations 
receive more favorable treatment of investment income than social 
clubs or certain other mutual benefit organizations. 

Possible Proposal 

The unrelated business income of trade associations could be 
computed in a manner similar to that applicable under present law 

(272) 



273 

to social clubs and certain other mutual benefit organizations. 
Thus, any investment income and other nonexempt function 
income of trade associations would become subject to the UBIT. As 
under present law, the UBIT would not apply to dues, fees, 
charges, and similar amounts received from members in connection 
with the association's exempt functions; certain investment or 
other income set aside for charitable purposes; or gain on certain 
dispositions of assets used in performing exempt purposes. 

Pros and Cons 
Arguments for the proposal 

1. Exempting the investment income of a trade association from 
the UBIT allows the organization's members to obtain an immedi- 
ate deduction for dues or similar payments to the organization in 
excess of amounts needed for current operations, but to avoid tax 
on a proportionate share of earnings from investing the surplus 
amounts. If the member had retained the surplus and invested that 
amount itself, the earnings thereon would be taxed in the year 
earned to the member. While investment income earned tax-free 
by the organization may be used to lower member payments (and 
hence member deductions) in later years, the member still has 
gained a benefit through tax deferral. 

2. The broad exemption provided for investment income and cer- 
tain other nonexempt function income of charitable organizations 
(sec. 501(c)(3)) can be justified on the ground that such organiza- 
tions lessen the burdens of government that otherwise would have 
to be financed through tax revenues, and serve a broad class of 
beneficiaries within the public at large, rather than simply mem- 
bers of or donors to the organizations. By contrast, tax-exempt 
trade associations generally operate to provide facilities, goods, or 
services that benefit their members. 

A trade association can be viewed as a conduit or agency-type 
entity, since the organization operates on behalf of its members to 
promote the line of business to which they belong. To the extent 
the organization receives member payments for purposes such as 
advertising the goods in that line of business, exemption from 
UBIT for member payments may be justified even if exceeding ex- 
penditures within the organization's taxable year. However, this 
rationale does not extend to investment or nonexempt function 
income of the organization. 

Arguments against the proposal 

1. It can be argued that the analogy of trade associations to 
social clubs is not persuasive. The very purpose of a social club is 
to provide private benefits of a recreational or social nature to its 
members; accordingly, Federal tax benefits for such organizations 
are limited for the reasons cited above. On the other hand, a trade 
association is entitled to exempt status only if its activities are 
aimed at improving the business conditions generally of a line of 
business, as distinguished from the performance of particular serv- 
ices for individual members of the organization. Thus, it can be 
argued that the special UBIT rules for social clubs (or certain other 



274 

mutual benefit organizations) are not appropriate for trade associa- 
tions. 

2. If the members of the trade association had carried on directly 
the activities of their association, they generally would have been 
entitled to deductions for such expenditures; by contrast, personal 
expenditures for social or recreational activities at a country club 
are not deductible. Hence, it is not appropriate to extend the tax 
treatment of social club investment income to trade associations. 

Revenue Effect 

[Fiscal years, billions of dollars] 



Proposal 


1988 


1989 


1990 


1988-90 


Unrelated business income tax (certain 
trade association income 


(1) 


(1) 


0.1 


0.1 



^ Gain of less than $50 million. 



2. Excise Tax on Net Investment Income of Exempt Organizations 

Present Law 

Under present law (sec. 4940), private foundations generally are 
subject to a two-percent excise tax on their net investment income. 
This tax was imposed so that foundations would share some of the 
costs of government, particularly the cost of administering the tax 
laws relating to exempt organizations. While the section 4940 tax 
sometimes is referred to as an "audit fee," the tax receipts go into 
the general fund and are not earmarked for IRS use relating to 
foundations or other exempt organizations. Further, although the 
tax rate has been reduced since its enactment in 1969, the tax reve- 
nues for fiscal 1986 exceeded the total IRS costs of administering 
the combined exempt organization and employee plan programs. 

All tax-exempt organizations, including charitable and social wel- 
fare organizations, mutual benefit organizations, and pension 
trusts (sec. 401(a)), generally are subject to tax on any unrelated 
business taxable income. However, a specific statutory modification 
to the unrelated business income tax provides that the tax does not 
apply to dividends, interest, royalties, and certain other types of in- 
vestment income, except where derived from debt-financed proper- 
ty or certain controlled organizations. 

Possible Proposal 

An excise tax of five percent could be imposed on the net invest- 
ment income of all tax-exempt organizations, i.e., on the sum of 
gross investment income (including interest and dividends) plus net 
capital gain, less the expenses of earning such income. This excise 
tax would apply to all corporations or trusts that are tax-exempt 
from Federal income tax under section 501(a), including charitable, 
educational, religious, and scientific organizations; social welfare 
organizations; labor unions; trade associations; social clubs; other 
mutual benefit organizations; and trusts forming part of a qualified 
pension or profit-sharing plan (described in sec. 401(a)). 

Pros and Cons 
Arguments in favor of the proposal 

1. In times of large Federal budget deficits, all organizations that 
benefit from the expenditures of the Federal Government should be 
called upon to contribute to reducing the budget deficits. Organiza- 
tions that are exempt from Federal income tax benefit from direct 
Federal spending — for example, for national defense, maintenance 
of the banking system, aid to interstate transportation, etc. — as 
well as from Federal tax expenditures, such as exemption from 
income tax and, in some cases, the itemized deduction for charita- 
ble contributions. Accordingly, like other institutions in the econo- 

(275) 



276 

my, these tax-exempt organizations should not be immune from 
sharing some of the costs of government through a modest excise 
tax on investment income. 

2. The proposed excise tax would not apply to noninvestment 
income of such organizations, such as dues paid to membership or- 
ganizations for their exempt purposes, charitable contributions, or 
related business income (e.g., tuition paid to schools or patient fees 
paid to hospitals). Accordingly, the proposed excise tax would have 
a limited impact on the activities of exempt organizations. 

3. The proposed excise tax could be "sunsetted" so that it would 
not apply once the budget deficit is reduced to a specified level. 

Arguments against the proposal 

1. Investment income of most tax-exempt organizations has been 
exempt from income or other Federal taxation since the inception 
of the tax statute, except in limited situations (such as debt-fi- 
nanced income or the excise tax applicable only to certain private 
foundations). This exemption reflects a recognition that many 
exempt organizations perform functions that lessen the burdens of 
government that otherwise would have to be financed out of tax 
revenues, promote the general welfare of the public at large, or 
contribute to the economic well-being of the country through pro- 
motion of business and labor. 

2. The imposition of the tax would reduce the funds available to 
and needed by charities, social welfare organizations, and other 
exempt organizations in carrying out their nonprofit activities. The 
tax thus would adversely affect the beneficiaries of these programs, 
including the poor, the elderly, students, hospital patients, the en- 
vironment, etc. 

Revenue Effect 

[Fiscal years, billions of dollars] 
Proposal 1988 1989 1990 1988-90 

Excise tax of 5% on investment 
income of exempt organizations 3.5 5.5 6.0 15.1 



3. Unrelated business income tax — equity kickers on loans to 
business ventures 

Present Law 

A tax-exempt organization must pay tax at regular income tax 
rates on its unrelated business taxable income ("UBTI"). If a tax- 
exempt organization makes an equity investment as a partner in a 
partnership, the income it receives attributable to the business ac- 
tivities of the partnership is UBTI. However, certain passive invest- 
ment income, such as interest or dividends, generally is excluded 
from the definition of UBTI. 

Due to the UBTI exception for passive investment income, if a 
tax-exempt organization makes a loan to a partnership, the inter- 
est it receives on the loan generally is not UBTI. However, it is fre- 
quently difficult to distinguish a debt investment from an equity 
investment. Court cases and revenue rulings indicate that a loan 
made with a significant "equity kicker" can still be debt, and no 
portion of the amounts received are other than interest, even 
though the return on the equity kicker depends upon the entrepre- 
neurial success of the venture. Even a return based on net profits 
may be considered interest on debt that is not UBTI, although eco- 
nomically it may be virtually identical to a preferred equity inter- 
est in the partnership. 

In other contexts in the Code, a return based on net profits is not 
considered sufficiently passive to qualify for certain tax benefits 
that are available only if the recipient does not engage in signifi- 
cant active, business-type operations. For example, such a return 
generally would not constitute qualified income of a real estate in- 
vestment trust (REIT). If such nonqualified income exceeds speci- 
fied limits, the REIT no longer is treated as a passive conduit, but 
is subject to entity level taxation. A return based on gross receipts 
generally would be qualified income of a REIT even though in 
effect such amounts might produce a return based on net profits in 
certain circumstances. 

Possible Proposal 

The income of a tax-exempt organization from a partnership in- 
vestment involving an equity kicker could be treated as an equity 
investment that may produce unrelated business taxable income. 
This rule could be limited to cases where the return on the invest- 
ment is based on net profits of the venture. 

Pros and Cons 

Arguments for the proposal 

1. Tax-exempt entities should not be able to receive aniounts 
based on an increase in the equity value of a venture without 

(277) 



278 

paying the same unrelated business income tax they would pay on 
an investment designated as equity. 

2. Tax-exempt entities should be subject to at least the same 
standards of passivity, with respect to the income that may be re- 
ceived free of tax, as apply in determining whether a real estate 
investment trust is taxed at the entity level. 

Arguments against the proposal 

1. Tax-exempt entities should be permitted to maximize the 
amounts that they may receive free of tax, to enhance the funds 
available for their tax-exempt purposes. 

2. Tax-exempt entities should not be held to a stricter standard 
distinguishing debt from equity than other investors. 

Revenue Effect 

[Fiscal years, billions of dollars] 
Proposal 1988 1989 1990 1988-90 

Unrelated business income tax — equity 
kickers on certain loans (^) (^) (^) (^) 

1 Gain of less than $50 million. 



279 



»o o o o o o o 



oo»o cxD j;j^oi,-Hj;^Qq 



05 CO CO T-H CO 1—1 rH 

T-i o o o o o o 



OO O "-^0~~-'^0 



OSCO COr-J CVJT-HrH CO(>J CO ^t~ ^^CO 

»— I O OO OOO OO o -^--o^^o 



rHO O'"-' OOO OO O ~^-'0'-^'-^<0 



hJ ^ .2 



! 



^•5 

I 



at 



> 

^^-^ >^ 
O ?3 aJ 

o 






?^-^-!=! 



nJ P 



W 



'^rt -^ >> 
+j o ^ 






cn 
bo 



bD-M 

s p 



(=! 
cc cC pH 



-M 



13 



S.S2 
c 

03 
O 



(1} iJ O p^ 3 



03 



,a Q 



o 

1— H 

o 



*-i ►=! C3 rrt S-t 



OS 












0) OS <u <ii 

53 be o) C ^ D 



CO-'H 



OS 
be 





6 

8- 
S> 

— ' o 
09 be 

beg 
fi'-r 

•'-' 4j 
Xi . 

CO CO 

03 3 
bc_r 

o 03 

OS be 

1—1 

f. ■ M 

o 5^ 



0) 03 



(O 






2 o OS 

X X ^ 



OS 

o 

OS is 
5-1 W 



03 



^ -^W W W g H P5 



03 OS a P 

. . . ex 
03 JO O 



G 

03.2 



tiq 



rH (>J CO -^ 10 



O 
O 

2PLh 
o . 



r-( «4-( 

^ O 
G 03 



TT > (D *^ , '-; bo 
a ^ M ^ -^tiS ^ 

G ^ 03 fi !^ 5 

^^1 2.2^1 









oa CO 



— ' ' — ' O CD J-- 

'^" 10 OQ 



280 



C^ (Nl OS "^ CO CO 

O O O 1-i O 1-H 



oqtqo c<ii-ji-< T-iio 
«OC0i-H ooo c>uo 



o o 0<0 ^"O 



OOOqcO t-Ht— ii— I -^05 
(M" t-H O ooo CO o 



rH rH (M CO C<1 »0 

oo ooo o 



CO C^ CO ^'^■^ '^ °° 

c^i T-H o o^-^^-' CO 1-i 






n 



T— t I— I T— ) CO I— I -"J^ 

o o o o o o 









3 
> 

I? 



o 




CJ 




o 




cS 




x> 




o 




H 




^ 








o 




^ 


a> 


o 


o 


o 


*> 


^ 


CD 


tM 


W3 


o 


03 


3 


o 



03 O 
g S 

ooaoo 
0) y 



tn 



Sh in 
PQO 

(NJ CO 



rH O) <-> 

.5h N W TO 

M 0) 9J 13 

5h Sh 0) '^ 

ccjd 6 § 



1— ( 1— ( CO 

od i-i o 



CO 
O) 

> 



O 

o 



so 

St 

1^ 



en 



o o "^ 






bfi 

_g 

o 

$-1 

09 
O) 

a> 

be 
03 

Jh ^ 
m CO 

O ^ 



'T3 



„ 0) 

03 O.S 



;::3 5 ,— I (M CO 

o . 
" 03 



■-H en 9< -i^ 



CO t-; 

CO i-H 



OS 

m 

•rH 
ft 

03 



CI 
en 



.„ CD 53 .S 

03 -i^ <D jT eg <D fC 
^ »-H (M CO g 



u 



(M 



281 



CX) i-H O I— I 

50 (>j i-i T-H 

(>] 1-1 



LOCO t-^OqiOrH (MOO C0CX)CO O T-l-!*< rH t- 



CO LO 05 "Tf 
C4 t-^ CO o 



C<j Oi (>] CD (M 

T-H* O T-H O O 



1-H lo i-Hcooq Lo LOCO cx) t:~ 

CO CO CO T-i lO (m' Cvi CO r-^ o 



CO -<* CO -"^ 

c<i t-^ CO o 



(>J 05 (^J CD <M 
T-i O I— i O O 



»-H CO »-H CO 00 CO COO O CO 

COCO cot-Jlo oj (m'co eg o 



t-J (>1 LO -"^ 
(M* O^ CO O 



00 

o 



oa CO oa iT" 
T-i O O '-' 



oo 

co' CO 



1-J CO t-. 
CO r-i LO 



CO t-^ CO "^ 
t— i T— i I— i O 



X! 
Xi 



CO 

«^ 

OJ 2 03 

-^ to ^^,^^^ 



OS c 

O) 



Qi CJ 
4J n 



<U 



0) 



(U 



22 

^ 

0-^ 



Qa 



s 



01 



bb 



c 

y 

;-i 


a 
o 

LO 



S if 

TO "fH 
^.^ 

2 <n 
O ^ 

gOPQ 



o 



'u 


'o 
o 

CJ 



T3 






I- 

2 2 

^^ ^ 

CS O 

-•J 13 _m 
^j "o 

.2 ca X 

y K^ 

X s ^ 







tn 



O 
T3 S 9 O 

g-^ fl o a3 
^is $ 8 s 



f^ VJ M/ 



CO 



o o 



13 O 



•-^ jg I— I l-H 4J 

^•§ dxi cj 



(M 






a. 

o 

iO> 

>^ 

pJO to 
03 

to -M 

X.2 
O 

8^ 
^8 

-t^ 

ft 
m ft 

Oj fl) 

0--H 

t) -pi 

fir?-: 




O 


ft 
LO 



cC ^ 



>ȣ 
CO ca 
«-. <i> 

c2 ^ 

j^CO 

0^ 

.2 X 
o <A 
X +^ 

M S 
03 2 

o S :3 

X J:? ft 

0"^- 
o 



CI 


o 
u 

ft 

LO 

u o 

CO ^ 

s>^ 

<1> ^ 
T3 CC 

£H 

O -M 



TJ 



ftW 
. . 

CO 






o 

CO 



s 

ft 
"3 





o 
X! 
ft 

o C 
cs o 

o 

tn C 

O 







-^"W^ 



-M HH 



^ s 

*^ 03 

03 U 

0-3 

^ ^ = 0c« 
to — 

o 
»^ iS [2 9* S5 

U^ CQ c ^ 
ecu <3>lS <1» 



o^ 



Si-go 

S 2 ?2 ft S5 



O T3 







282 



eg CO oo eg 
i-H o o o 



CO T— I CO 

o^ T-5 o 



-rt* 7-t CO T-i O -^ T— I 

OO O O CO o o 



O ?D 


ZOZO 


^ ,-J ?o 


I— ( 


- OO 
CO'* 


LO O t-^ 

1— 1 CO lO 


Cr- t- 


LO?£5 


(M ,-|05 


LOO 


O '!J<' 


to ocx5 



■^^ T-H CO 1^ 


00 


'^ rH 


05 LO 


CO 00 


(M tH T-H 


O O OO 


OJ 


o o 


CO o 


oco 


lOOOJ 



CO T— I eg I— I 
OO o o' 



lo eg T-H 

t-i O O 



Tt CO 
CD O 



oq eg o o co 
oi eg* to o oj 






PQ 



O «4-l 

o o 

O M 

eg g 
o 



<u 



CO .2 



O) 






CS 



O) (» 
• S >>§ 

3 o-r; 
^£ ^ 

tM «4-l . 

o o 



: +J 


o : 


: C 


(U : 


: <l)'T3 : 


i 6 


•l-H 

> : 


: fi 




13 


«S 1 


> >-i 


O i 


: c) 


> : 


: fi 




: <u 


-i-*^ : 


: o 


a; : 


: a 
• o 
: ^ 


S : 


:-S 




: <^ 


a* : 




a> : 


: 'o) 






o : 


: »H 


QJ . 


: 0) 


»H : 


1 s 


: 
-M : 


: 3 


CO : 


: 03 




: fi 


M : 



^ ^ ^ 
> > bX 



(1> 0) 

3 3 



o 

09 

s 

be 



3 
o 

• l-H 

o 
a> 

u 

(JJ 
b b^ I 

. O 5-1 3 O 
- O <1> 



3 — - 



>< X X 

03 ^ ^ 

~M -M 4J 

-M -t^ ,|j 

^ 9. 9. ^ 

^ a O Ci 
S o o S 
m ^ ^ 5h 

t! a Oh a 

>^ ' 'I 

C*ooo 

Jj T-H T-H ,— ( 



be O) 
X 3 Vi 

0) <l^ M tn <U *« 
*H }rl 5^ >; ^H 03 

>-< '^ a O '-' O) 



CC 
(U 

o 

CO 

<3i 

X 

a 

en 

•pH 

o 

O) 

a> 

03 

«+H 

o 

03 
O) 
-M 
RJ 

»H 



Ph 

CO 
T-H€^ 

€^ 

005 
&(00 

^S 

^C 

03-'^ 

ccg 
o ^ 

^00 



to S 
O 03 

.2 3 
§° 

bOT-H 



3 03^30 



o 

be 



S.2 

OS 3 

O r— I 

• Sh O 
to CD 



w O 

« Co 
-3 :355 

'^ P-T-H 



PQ 

03 fl 
-M OS 



o o 

•l-H -l-H .^ 

Ph Ph o 

CO CO 

el fl 
o o 



o o 



1— I I— I ■-; 

03 OS O 



O O 

X x 

OS OS 



1^ ^ 



IK 
^ p< 

03 O 

CO OS eg 

+J TO ^ 

gpq 
w 



0) g 

^ 0) a> oj^ 

•^ P V. ^--H 

« J2 03 OS 5> 

+1^ a jIh >^ OS 

O 0) 1 I 5h 

»H 03 to o aj 

0) 03 eg to P. 

to ^ cyj c/j c/3 
^ 03^^^ 

eg o '-H eg CO 



283 



CO Oi 
CXDrH* 
r-l(M 



00 



t-; r-H Oi tr- T— ( ■'^ CD CX) t> 

S^ ^' ri C0tr-^05.-H(>j ^ 

<M CO C<I i-((>JOa,-l(M rH 



05C0 -^ t- OJ ; 

odooo o' 



lOC£> 



o 



OS 



od 



o 



lO CX) CO 00 ■>* 

■"^odoco t-^ 



00 






050 (M 



ir- 


t- 


O 


IOOI>;00 10 


Oi 


^^'-jtM 


lO 


05 


t-" 


'^oios CO t>^ 


'*' 


oi ^-^oo 



to'od 



00 



(M 



tr- 
io 



O 
00 



u 
a 

a 

I 

o 

€«- 



bo o) a> o 
? (=1 SS 0) 

-U 03 O ■ 



0) s g fi 

1^ ^^ « <,^ 
> O 3 ^ 



-cl <D 



.o 



Bk<^ 



o 

a 

6 



o 



be 



^ to 

ft -*^ 
o y 

UU-2 S'S §'-^ S 

o'O h to e 
S S S S-S-^ §^ o^-^ 2 ><oi^ 

s.S S S "1 « 



o o 



cij oi aj '^ -"^ 

rj ^j ^ JH O) CO 
X cc C3 oJ -M ■ 



(UT3 
bJD (U 

(u ;3 






CO ^ 

CO O 
0) o 






■rte4-i 
m O 



(U 



o 

T3 

a-S - 

• ^ Sh _ 

rH <1> 9 



t-; CO 00005 
"*" Oi Oi ""^ t-^ 



o 

lO 



OCOi-iC<J 

oooo 



> 
o 
o 



OJ 




fi o 
fl oJ bo S 

2 ^H S X 
^ <U ft <u 

•-H 05 03 ]:0 bo 
OS bo bo'^'-' 
"^u ^ >,>,^ 



> 
o 
o 



'T3 

X 

a 

bo 
i-l 



o o 
pfi^^bobo-^ P<. 

<U 0) (D 0) (D O) CO 

CO CO (O CO CO CO -M 

^ ^ 03 ^ ^ ^ r^j 

0) OJ O) 0) Q>H 

V^ ^ 2; ^H ^H !hCO 

'^ O G O <D Ot-j 



0) 



03 

CO 

c 
o 

CO ^ 
I— i O 

2t3 
c2 C! 
03 



bo^ .2 

0) O o 

., en X 
OS 



OSTS 



Xi 



^ X e 

crt <T« l-i 



o a)pJ3 

. CO CO o . . _, 

X o3.2ii OS OS 

S<c_. '^t^'73 (U'-i* ca 



oiXi on3 a)«+H 



bo 






oo 



284 



o 


o 


00 tr- 


CO CO Oi lO 


O Oi t- t- 


-^ t- Oi 


T-H 




C) c<i 


CO od c<j c<i 

t- LO tH (>3 

C<I rH T-H 


CO ^ CO »o 

lO 1-H 1— 1 I— 1 


coco o 

T-H 1—1 LO 


Oi 


I— t 


<x>o 


'^ijoqo^o 


coo 'St "^ 






o 


^' 


o 


O T-1 


CO C75 CO O 
O LO -^ T-H 

1—1 


c<j t-^ t-^ CO 






CO 


t~ 


00 


(M O 


t- CO <M LO 


t-j CO oa Oi 


-^ LO 00 


'^ 


oi 


O .-H 


ood T-J t-^ 


o CO CO uri 


t-^ LO 00 



O LO "^ 



'St 
'St 



eg 



t^ tS -3 



fQ 



S 
a> 

X 

s 

o 



m 

o 
ft 

s 

o 
o 



^ : CO 
13 X as 

-- o 8.S 

» o C o 
H +^ .-t^ g 

i Is §< 



O 

• i-H 

0) 

bo 
03 

;-i 

> 

03 



03 



03 



c^ _s 1-^ •« 






lO CVI 00 o 

ai o t-^ to 
co^ C<J 



^3 

OS 

b£ 

'm 
o 

O 

U 

a 

(=1 
o 



CO CO T-j CO O (M O 

o CO CO CO ai 00 ai 



0) 

o 

X 
0) 



CO 
(U 
X! 
03 
-)J 

u 
tn 

OS 
m 
cu 

03 X 

X 
03 



ij 

-^ T— I 

^ I- 

>< X 
^^ -t-a 



Ph '« Jh 0) 

a.^ ft g 

Jh f^ ^H 'l 
<-' -fH CJ QQ 

-(J ^_> -t^ 05 
C! fl fl 1-1 

S 8 S g 

c— r>w>.,ww „>^^ftftfti: 






., c ei 

_0 O) 0) 






TO ri 

o| 
2 " S 

=^ S fl 

^^ I 

"^ 03 fH 

H "^ 9. 
-Q3 



X >< X •• 



M <» M 0) 



03 

•I-H 

> 
• 1— I 

ho 

•r-H 

X 

o 



|2g 

> O Q) 

!h ;-i 0) 
03 03 cj 
<I> 0} S 

<U O) g 
C m (U 

OOfi^ 

^oJco 



u u u 

_ O) 0) O) 

g ft ft ft, 

<i) LO LO t>- 

c . . . 

^<i) rH Oa CO 



"w*^.!!; 



2^ 'C 03 ,Q (JTi OJ 






oq 



OCi 



285 



<M 

00 
1— 1 


05 




t-rH 

oo 


CO o o o' ^^ 


05 
O* 


05t>; 

?DO 
r-tlO 


COC£> 


00 ?o 
1— ( t— 1 


too 


00 
00 


CO 

I— t 


00 

1-5 

•—1 


OO 


00 00;:^ CO ;:^ 


O 


00 '^^ 


«ooo 
0(>i 


LOCO 


«Otr- 
OJCD 






00 



05 
05 






(M 



C4-1 
O 

-»J 

o 

(U 

en 

> 
o 

CO 

en 

> 



a> 






O 2 <» ,„ 



o 



.^00^ 

rO^O)'^^ 

: ja a> o 
■ a g g<M 

rr> Qi M .S , ^ 

1.2 2.^1 § 

CO X c ii 53 OJ 
CO (U S <U S'T3 

o cs ^cA'^'^ 
amioXi3'3 . 
^aco^g.^-g 



COt-H 

00 



t-co;7^co;:;^ 
i-io'-^O^-' 





(Nit- 
CM 


10 'i:!* 

ooi 


0(>a 




oC^C^ww 


T-H 




OTt 

i-Hc6 


CvlCO 
0.-H 


CO 00 

COCQ 





o 

o 
o 

00 ai .. 
00 0) en 



CS 

s 

a 



Jso S g^ ^ £ 



ill "jail 

.9 5 fl^ S<-Cg 



.2 03 






09 



cc 



t) 



^. 



•l-H 

•1—1 

_g 

en 



•'^ :?• ^ oQ -S T=^ h2 

^ <Ui-H(M^T-l(MCO 

^T^ t . ^•X ^^X ^T. N*-^ N^*^ '•^-^ 



2^^ 



cs fl a> 

O C 0) 

'^ CO g 

^-.-^ (D 



S' <=• *^ en 

o .-^ o -^ 55 

en <u€«- - c^^ 

+J -IT* Kn 2: «^ -u :3 3 



>>>> 



a 

O 
O 
1—1 

€«- 

O 
'^ 
00 
€«- 



C <UO'^ 
.S(MCV]0 

ess; C '^ 






a>0 



> So <i> Pi o oi2 o-=i ^ 



en 






X 



o 

<: 

'13 

C! 
CO 

< 

h— ( 

O 

• i-H 

en 

CJ 

X 




«4-; be t) ih — 



cd 



i«i5 a)i-H 



CO ^as, Eflpojco 

3 dxi g ed 



^ 



->* 



U5 



286 



-«* -rf* ,-t 


(M i-H 


00 


1—1 to 


(M 


^Oi 


(M 0:1 ^^O 


Gc5coo 


oo 


"TlH 


'^t CO 


o 


■-^o 


co-^^o 



C<J CO 

CO 1-H 



o 



Oi t- 



'CO 
'O 



o r-5 --^o 



CO 



^ (M 



-CO T-H Qo ;:7-(M 

'O O T-H ^--o 



o 00 ;7' 
(>i o ^ 



00^ ;r 
00 ^ 









m 



o 



a 

u 

ft 
o 



0)0) 



j:3 
•I— I 

o 



o 



O ^ 



03 -M CS 

^H rH fi 

• ■ « fl 0) 3J ^ „ ^ 

t»0o OT3T3 o Oc2 

•^ 'm 'S '^ 'T3 'm *m _ 

a> 13 3 Oji 13 13 C 

- - o p a» <u S 



fi C 



03 O 



O 

UO ^ 

03 



03 



wc2 

l-H ^^ 

o) 5 
-'-' .2 



2 a> »s 

^ O (S 

OS X! " 

,.. 0) _ 






•i^oJoS&^^oSoS^,- 
a> ft ft 0) ^ Ph ft 



H 



WW 
6 "^3 



2 fl fl 
5 ca (D 

fi.2 ^ 
2 Jr. 0) 

fttJ ^ 

'q.^ S-h OS 

0) cd ft ft 22 
o j2 ^ c^q 00 

So 





-tJ : 


: $H 

^1 


C : 
03 : 

a i 


: 'ft 




: S 


a 1 


: 3> 


•pH • 




CO : 


: t+H 




: 


Ti : 


is 


C : 
03 : 


: fl 




: O) 


M : 


: -i-i 


^ : 


: fl 


<u : 


: oi 


: 


: >iG : 


: fl 
: 


"4-1 : 
: 


: w 






(D : 


: OJ 


-M • 


: J3 


03 : 
: 


: fi 


ft : 


• 


u : 


: cH 


: 




: 


•Ti 




: 0) 


t-i : 


:r£3 


,0 : 


: tn 


^-H : 


. -pH 




: C5 
: ^ 


: 

•1— 1 


: ^~' 


CO : 


: bD 


^ : 


: C 


'0 : 


• -r-l 


X en 


be 


0) u 


i'TS 


a 




o 

o 

T3 
(U 

U 
(U 

o 

l-H 

ft 



rj O -(J n3 

H I— t o r— I 

O .So 

0$©^ 
O of 03 



bD 



!h 
"(J 

O 

ft 

o 

LO 
g CO 

.2 CJi 



o 

2 -"^ 
'S OS 

-g 6 



03 

03 fl "£ 3 
M^ 03 '-' 

^tS oS'^ 

-M ra ^13 CD 

1— I C<1 CO p, 



287 



00 

o 



CO 

o 



05 t-; 

i-H CO 






O 00 (>J 
■^ CO o 






00 


05 


(Nj -^^ i-H 


Cvj 


o 


CO 


oi T-! o 


o 


CO 


to 


05CO;7^ 


1—1 


CO 


ai 


oo ^-^ 


o 



00 lO CO 

ooo 



CO (NI T— I 

ooo 



CO 


CO «o 


'^ 


CO T-^ 


lO 


tr- 


OOLO;7 


o 


■<^* c^' 


T-i 


i-H O 


'=35 


io 


oo ^ 



CO Oa rH 

ooo 



CO LO 


^ 


00 i-H 


o 


tr- 


LO CO ;7 


c<i T-J 


o 


o o 


CO 


OJ 


oo ^ 



OJ rH T— I 
OOO 






o 
fi 

<u 
bD 

fi 

fl bD 

.2 c 

> s 

o S 

Vi o 

ao 

top cc 

1:2 CO 

fl CO 

§^ 
'^ ^ 

< 

CO 



a; 
bD 
fl 

B 
o 
o 

^g 



aj3 



bp >^oo 



a en 



;30 



s o 



o fl 

c §0 
p §0 






bpoB^-S G ^^00 

^^^■^ g^ — 



(/} 

•rH 

<a 

> 

o 

<u 
o 

O P 



.S s 

CO *:j 
-M ^^ 

^-1 , 

iS to 

o 

%-i 

O Jh 02 
Q 0^ O O) +J 

c^ (D O 0-5 a 
O 2 <^ S (» 03 

.22" 



03 

o 
a> 

o 
•I— I 

o 

6 
o 



a 

be 



<D M CS 
to PT3 -^ -^ 



> cud S 355 2t-' 

fo T-t (M g T-H C<J 



o a' cd 
cs.S ^ 

> M OJ 

duO 
0) 0) ^^ 
&, >P 



^ fc! .2 S '3 bD :=J 

^.S'^^^'43 a 
b-2^ c §> 9^ 8 

Cr t> G CO — "S _Q 

« golf J 



e 



c5 



^ G P 
J~i CO 

I G CO 
^^^'^ 

o G 
^ P 

e.a 



O) 



> s 

_ O c3 
(>J bc^ 

2 H^ 

CO pj 



P 

u 
bD 






^ 


cC 


-M 


-M 


•i-H 


P 


^ 


^H 




c« 



O) 


be 


^4 


fl 





bD 
CO CJ 
G • r3 
P^ 






S ai^ p bfi^ 
<<^PQ go 






p 



cC 
m 
P 

p 
•^ p 

'co ^^ 

Pk > 



fl P 

•2S 

*""! -I-H 

1^ 

•^o 
00 

10 T— I 

> > 
p p 

en en 
-(J +j 



p 


P 





y 





0) 


u 


$H 


tn 


c« 


en 


en 


P 


P 


?H 


u 


bo bJO 



'^■^ 

en en 

S 6 
^^ 

!h U 

.P^ 

a> p 
a a 

(D p 
c^co 



«<-; bD 



-^ OS 



288 






CO ^ 



->* ^ 



Oi-H 
i-H O 



oo 



IX> rH CO 

ooo 



o ~^ 



"^ CO ; 

oo 



OO 



t- to lO <M T-H -"^ 

»-loc5ooo 



t- (M CO »-l ^r-i 

o o' o" o' ■~' o 



CO 

p. 

CO 

o 

H 



o 

I 

o 



O^ 

O 

CO 

H 

Q 

H 
< 



CO 



m 



> 
•1—1 

OS 

m 

a 

a> 
J3 



!3 






c^ '^ 



o 






a> 
Eh 



a 

.2 

0) 

>^ 

8 c3 
^^ 

o o 
en 



O "— 



o ~^ 



tn O 

fl CO 

•§^ 
§^ 
-tJ no 

U (4-1 

o o 



o ^ 



OO 



(4-1 

O 



C3 



03 

CQ Vh 



> 

o 

tn g4c+H 
g S o 

^ X c 

3 <D O 

t^ X a 

c _, <u 
.2 pL>< 

o cS 
w . . 

od 



o 

00 



o 

«4-( 

n3 

CD 

bo 

C 

ca 
o 

• 1—1 

o 
'O 

> 

• 1—1 

<u 
o 



CO 

o 

ca 
o 

Oh 

o 
o 

o 



2^"S 
^ ?^ <K 

2^S4C 

■ t- CO 

c 
o 



ca 

C! 

o 

CO 

u 
<a 
a 

.2 

CO 
O) 

ca 
u 



o 

ca 

c 
o 
o 



^t ^ 



(4-1 

o 

0) 

o 
o 



o 






'O CO 
:3 CO >i 

bB a o 

0) £H 2 



3 
ca 

c2 

"» s 
fi.2 

"^ rt 

(a o 

-^ s 

g ca 

O «4-l 

• i-( o 

"_§ 
S^ 

O w 
09 (U 

<=! fe 



t- 03 (M I-H HT^rH 

OC>C><D^^C) 



CO I-H 

oo 



CO 

u 

a 

•1—1 
u 
c2 



ca 
a 

CO 



o 
o 
o 

o 



<u 



- «< <i^ 



CO 

si 

O X 
CO u o 



.3 <a 












(U 



O 03 

2 <u g S-;3 " 
S/tS o ^ <? - 

•^ tb -tj 



ca 

bp 

PhC o 

4j a)«45 




ca ^ 0^3 «4-H 



289 






bo 

PI 

•l-H 



OOOOOOOO O OOO OOO"— 'OOO 



■^ C<j T-J C<j ;:7^ CO i-H rH "^ '-j I-] ;:^ r-ir-^r-i^r-^'^CO 






'O 



o o "^ ~-^ ~^ o ~^ "^ 






09 



0) 

o 

ITS S 

a.se 

g-^ 8 






«3 -^ 

•l-H '""^ 



•3 o 



0) C 
tin a> 

^ CO 
C > 0) 

a® o 

3 fi m 

2.2 fe 



C a> 03 

c3^.2 
■ > 






p p. 2'^ 3 



C3 
C S 2 : 



u 

c 

CQi-^ 

CD S 



lull 

(«£ aj>-H<Mco 






3Sog 

CO O **"■ ^ 
flO CO > 

TO LO O ^ 





> 




Vh 


fl 


<u 


O 


CO 


•i-H 


(1) 




^ 


o 




3 


>» 


'C 


C 


(U 


0) 


QQ 



O) 

f=! 
0) 

u 




p- o cj o o 2 

6 ^ <s 



-^ lO <X) t- CX) Oi 



AH 



25 •>-< ni 



'-H CO O^ 



t-; lO CO 

(>i o o 



CO o o 



00 CO l-H 

oo o 



■^^ CO 



0) 

boc2 
<=! J? 



o S M en 



•'^ O ^ CO 

^ fi S s 

■ft «3 "^.^ 2 t! 

5©^ 0) C «3 P 

o =^ o SfTS s 



6 .S 



o 

cc (U fl 

cd 

^ CO 

o a> 
a, o 

O 0) 



O t+H CO -^Jiei< 

S cC ^j oJ oJ W 

a* ^H c 1^ <i> 

<y 3 5 aax 



lc2|i 



KM CO 



Jo C C 2£ 

^ *■• ^-i /i\ ^ 
^H a> g 5 
C^a^ o 
miot-h e a 

<^ < S 



•-a a)«4-; bo 



290 



< 

Ex] 
CO 

o 

o 



s 

o 

I 

o 

Oi OS 
O -^ 

O 

CO 

H 

EN 

;z; 

Q 
H 

H 
CO 



o 



CO 

o 



CO 

o 



o 



o 



O Ut) 



oo 



CO c<j 



'^ 00 

T-H O 



"^ 



to 
o 



O O t-HO 



t-l •- ^ 



PQ 



en 

o 

u 

=( 
o 

CO 

Id 
-(-> 



^ "-LJ I 

oj <a M 

C J-i 

,— ( ^ 



0) 

$-1 



iS CO 
O 



0) 



CC 



CO -t:^ 

bo (D 
■^ 

"2 I CO 

§11 

T3 >» S 
II— I (M CO 



09 
O 
O 

bC 



o 

B3 

Ph<u 



cc 



CO 



o 

O CO 

CO 3 a> • ■ 

0) O «3 



0) o cd 

CO 0) ^^ 
0) >^ O) 






(U 



p^T— I (>a ;:3 '-M 

0) ^^^^ CU CO 



^ ^ 

j^ ii s 

C CO 

►^«4-< CO 

Co ^ m 

■T! CI >H 



10 O <N ; 



CO t- 

00 



CO ^ : 
00 



00 10 



OC<J 

1-S o 



00(>] 

00 



CO 


(M CO 


10 


-^ 


CO 


Ci CD .-1 ;:7 








r-i 


T-H 





T-S 00 "^ 



CM 



<s in 
flo 

0) 1—1 
o ~^ 

5n "» 

CI4 o 
O o 

n (53 

^^ Jh 
CO -<£ 

|8 

CO Q) 
U 0) 

CO .g g 

'=5 cj.2 
o.h -i3 

b£ be a; 
bD o O 4j 

^ -U -t-i 1^ 
."t^ ,-1 (M -Jj 



2" 
CO 



O 

o 



^313 



'5 ~ 



O T3 
CD 

0) ^ "^ 
^ Si O) 

^^ § 

rri p-"^ -J2 
.PlH 



cdx5 






291 



CO 


C^Jt-t- 


-^_ 1-J 05 T-H -^ 


o 


Oi-HO 


T— I >— 1 O O Ji^j 









CD to -^_ ;::;^ lo ^ lo ; 
ooo^-'i-i ^^ id 



;r;r;r;roq ;r 



O O) 

so- 3 

0) 



_JL TO -l-H ,— I 

Q.'W CO CJ 

O S 2 03 X 

a>Jo^ > fi 
/A tJ ^ ^ c 



^ en 
13 



LO;7 



a 

N 
• I— I 

O *H 

o 

§6 
.2 <X) 

Oi O 
8^ 2 

•l-H C 

t,B 

U 09 

1 ^ 



P N 
>-( a) 
Oh O) 

^ -If - 
O TO rj 

> 



X 
o <1> 

.T5 TO C ,^ 
-gt3-^ O 2 

o o"5b>'-S 



a-s.a 



.2 S 

CO 0) 

fl to 



13 o 



co-^ 



en 

0) 
. . . H ■ • 

toco t- MrH C<1 



CO 

c 

• I— I 

CO 

u 

O) 

t) 

fl 
o 
en 

M 
o 

'3 
cr 



CO 



l.s -^ 

.S'2 ^-^^ 
V. -2 " ts CI 






^ s 

»-i CO 



13 <u 



ca ja 



2 Oca's s 

is C S o 



03 »H +J 

tn > 3 

SO) 

F C 3 

.a o c 

. o > « 

era (K (u 9" 1" W 

;:3 cs S 0) - g'S 



?* -i-H d, 

C <D ,„ 

g c.a 






Sh *H C ^ 



C CO 

C CO 
<U cfl 



o c 



F Q 



cu.a I 

en H 



?3 "K 



O CO t^ CO "S C ™ 

r-i N CO Tf :2 ^ "^ 



o